I have some advice for you if you feel compelled to use margin heavily in order to produce the kind of returns needed to fund your retirement: Don’t.
That’s not just because margin can lead to intolerably huge losses that lead either to margin calls or your throwing in the towel at some of the worst possible times. The other reason for my advice: You don’t need margin in order to produce spectacular returns.
Today’s retirees (and those near retirement) are especially in need of this advice because many of them have come face to face with the awful truth that they haven’t saved enough in order to have the retirement they were hoping for. They think that they can overcome this lack by leveraging their returns through margin.
Chances are they’re wrong—and that they’ll end up being worse off.
Consider the track records of the various portfolios maintained by The Prudent Speculator, edited by John Buckingham. His newsletter provides the ideal laboratory for assessing the impact of margin because the service’s original model, the personal portfolio of founder Al Frank, relied heavily on margin. In subsequent years the newsletter added other model portfolios that rarely used margin and, when they did, did so only modestly.
The period from January 2000 to December 2005 is particularly illustrative, since that was when portfolios of both types—margin and non-margin—existed. This six-year period, you may recall, included both a severe bear market (the bursting of the Internet bubble) and a powerful subsequent recovery—over which period the S&P 500 SPX, +0.27% was essentially flat.
As you can see from the accompanying chart, the Prudent Speculator portfolio that did not employ margin outperformed the portfolio that did. On a risk-adjusted basis (not shown in the chart) the non-margin portfolio did even better, since its superior raw return was produced with much lower risk.
You may find this result difficult to fathom, since the stocks the newsletter recommended did far better than the interest paid on the margin balances. So the use of margin should have boosted returns. It didn’t because the Prudent Speculator’s margined portfolio incurred margin calls during the 2000-2002 bear market, forcing it to sell stocks at a loss in order to raise cash. But for those margin calls, it surely would have beaten the newsletter’s non-margin portfolio over this six-year period.
The investment lesson to learn: If you are going to heavily employ margin in your portfolio, you better have enough liquid assets outside the portfolio which you can draw on to meet margin calls. Of course, if you do that, you aren’t really heavily on margin after all—if you take all your assets into account rather than focusing on your equity portfolio in isolation.
But the even more important investment lesson to learn is that you don’t need to go on margin to produce impressive returns. Notice that the Prudent Speculator’s non-margin portfolio produced a 16% annualized return during a period in which the broad market on balance went nowhere. That means that, at least in this case, the newsletter’s stock selection had a greater impact on performance than the decision of whether or not to go on margin.
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Meeting margin calls isn’t the only reason why margin can lead us into ill-timed sales. Another is that few of us can tolerate the additional volatility to which the margin inevitably leads. Take the stock market’s correction that began in late January of this year, which so far has caused the S&P 500 to decline by about 12%. A portfolio that was fully margined would have lost more than twice as much—double the losses plus the cost of borrowing.
For the record, I note that Al Frank, the Prudent Speculator’s founding editor, was one of those very rare individuals who could stomach the volatility of a fully margined portfolio. His sales during the 2000-2002 bear market were not because he wanted to but because he had no choice. And, yet, because of those sales, even he was beaten by a portfolio that owned many of the same stocks but which did not use margin.
And if you are like most of us mere mortals, who find bear market volatility intolerable, the destructive consequences of margin-induced selling are even more undeniable.
Does this discussion mean you should never use margin? Ironically, Prudent Speculator editor Buckingham says no. In an interview, he said that there are some perfectly valid cash-management reasons to use margin that have nothing to do with trying to leverage your returns.
For example, let’s say that you have a big bill coming due—a child’s college tuition, or the down payment on a house—and you won’t have the cash to pay it for several months. Going on margin represents the easiest and cheapest loan you could obtain, Buckingham argues. Since your stock represents nearly universally-accepted collateral, you don’t have to go through any complicated loan application process to be approved. And the interest rate is lower than almost any alternative; the current rate, for example, is 3.5%.
What if you are one of those rare individuals like Frank who truly could stomach greater-than-market volatility? In that case, Buckingham says, you shouldn’t automatically rule out using margin, provided you have sufficient liquid assets to meet a margin call and to fund your retirement during the possibly extended period in which your portfolio is under water.
Forgive me, however, if I doubt you are one of those rare individuals. As Claude Erb, a former fixed-income and commodities manager at mutual-fund firm TCW Group, put it to me in an email: “The people who can truly stomach the volatility of a 100% stock portfolio are either catatonic or dead.” And notice that he was referring to a portfolio that was not using margin; a fully margined portfolio is twice as volatile as a 100% stock portfolio.
For more information, including descriptions of the Hulbert Sentiment Indices, go to The Hulbert Financial Digest or email mark@hulbertratings.com.