Wealth Decision #8- Don't Borrow Money to Buy Stocks

Wealth Decisions Podcast Transcript for Wealth Decision #8- Don't Borrow Money to Buy Stocks

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James Montier once said, leverage can turn a bad investment into a good one, but it also has the potential to turn a good investment into a bad one by forcing you to sell at just the wrong point in time.

Mark Lazarus said, a leverage portfolio forces you to act irrationally when markets are irrational, as opposed to acting rationally when markets are irrational.

The late and great Charlie Munger, who was Warren Buffett's right-hand man all the way up to age 99, he often said, Warren and I are chicken about buying stocks on margin.

There's always a slight chance of a catastrophe when you own securities pledged to others.

The ideal is to borrow money in a way no temporary thing can disturb you.

Very wise advice.

So in today's episode, we're gonna be talking about wealth decision number eight.

Don't borrow money to buy stocks or investments.

Investing with borrowed money or buying on margin is one of the greatest ways to two or three X your returns, but it's also a really good way to two to three X your losses.

I learned this valuable lesson very early in my investing life, along with many other individuals in the tech boom and bust from 1999 to 2000.

At the time, I was a new financial advisor and I had about 20,000 saved in a taxable investment account.

And I had it loaded at that time with some profitable tech companies, but also some not so profitable.com names in that portfolio.

At the time, the maintenance margin was about 35%, which meant I could invest another 37,000 on margin, making my total portfolio invested worth about 57,000.

So 20,000 of it was my own money and 37,000 was borrowed money as collateral.

The problem is if you use all your buying power to buy more stocks on margin and your stocks go down, you're gonna get what's called a margin call if your margin percentage drops below that 35%.

This means you either have to sell stocks to cover the margin call or you have to come up with cash.

Of course, I didn't have any other cash, but it was just one of those times where everyone thought you could do no wrong.

You could buy a tech stock and two months later it was up 20 or 30%.

I used to have people coming off the street when I was working at a brokerage firm that wanted to buy stocks.

They'd never bought a stock before in their life and wanted to come in to buy this tech stock or that tech stock.

There used to be an old saying that if the shoe shine boy is giving you stock tips, it's time to get out of the market.

And that should have been a sign, but tech stocks continued to go up.

So in late 1999, I kept buying more tech stocks like everyone else.

The difference was that every time they went up and I had more buying power, I would borrow more money to buy more tech stocks.

But as we know, what goes up must come down.

And the last stock I bought was a company that is well known today for its sizable stake in Bitcoin.

It was a small company at the time called MicroStrategy.

I bought it for about $102 per share right before I went on vacation to Mexico in early March of 2000.

Five days later, I finally was able to get a newspaper because back then, we didn't have instant access to stock quotes like we do today.

And the quote I saw on the paper was over $320 per share.

I had bought 250 shares and I had made over $50,000 in six days.

Needless to say, Drake's were on me that night.

And two days later, I was able to look at the paper and MicroStrategy was down to about 180 per share.

And then went down to about $100 per share in a matter of a week.

All tech stocks started crumbling and my almost $200,000 portfolio started crumbling with it.

Margin call after margin call, I had to sell stocks to cover each time.

And instead of selling more than required, I sold just enough to meet that margin call, hoping that stocks would rebound and bottom and eventually recover, but they never did.

They kept going down and many stocks during that period of time fell more than 70%.

Even some of the best technology stocks went down 70 to 80%.

And at the end of the aftermath, my portfolio was worth less than my original investment of 20,000.

This was a very, very painful lesson to learn, but I'm just glad I learned it when I was young.

I still will use margin from time to time, but mostly to fund something I can pay off in three to six months.

And I never use more than 10% of my collateral.

Leverage is powerful on the way up, but on the way down, it's like a falling knife.

And leverage is what caused the financial crisis of 2008 to 2009 and many other crises we've had in the financial markets.

Over the years, it sometimes feels like we never learn.

You know, Wall Street has had a track record of doing things like they did in the financial crisis because greed takes over.

Greed and fear are the two biggest drivers of the stock market.

Back during the financial crisis, big banks and big brokerage firms were leveraged in some cases 10 to one on CMOs, which were backed by mortgages.

So what that meant was that these banks and big brokerage firms could buy for every 100,000 in CMOs.

They were borrowing 10 times that to buy more because they felt they couldn't lose.

They were paying out really good income and it was during a time where these banks and brokerage firms could do this in a highly profitable way.

But think about that for a second, 10 to one leverage.

Does that sound smart to you?

That is why many of the big brokerage firms that were leveraged like this, either merged with a bank or insurance company, but it also brought down a couple of them.

Lehman Brothers was the not so lucky one.

They went under on September 15th, 2008.

Never thought in a million years, I would see an old, old brokerage firm like Lehman Brothers go belly up.

Now they have movies about it.

You've probably seen The Big Short and a couple other movies.

Margin Call was another one that really went back and looked at what really happened.

And it is pretty astounding to think that the whole financial system was on the verge of collapse.

So margin as an individual investor is very, very dangerous and it's a very dangerous thing in the financial markets.

The biggest risks of buying on margin is just the fact that you're using borrowed money and you're gonna act irrationally when things go down.

And you're gonna be forced to sell, especially if you're borrowing money against your portfolio.

But it can also be a double edged sword when you borrow money in a different way.

And I made one other mistake in my investing career as if I didn't learn a valuable lesson from the first time buying on margin.

I was feeling good about the markets.

I had some home equity in my home and I took out a home equity loan.

And I invested that money in stocks.

This time I didn't borrow money against my portfolio, but I was borrowing money against my most important asset.

And what ended up happening is I didn't act rationally.

I didn't make good decisions.

And when it went down during a period of time, even though it recovered, I actually ended up making bad choices because I had this money that was borrowed and it went down 20%.

I panicked and I sold.

So anytime you invest on margin without a long-term time horizon, you're gonna act irrationally and you're not gonna make good decisions.

So avoid borrowing money of any kind to buy investments.

The biggest risk of buying on margin is that you can lose much more money than you initially invested.

A decline of 50% or more from stocks that were half-funded using borrowed funds equates to a loss of almost 100% in your portfolio plus interest that you pay on that margin load.

So not a very good idea.

So let's say, for example, you buy 2,000 shares of XYZ Company for 10,000 of your own cash plus 10,000 in your margin account at a cost of $10 per share.

So you have a total of 20,000 excluding any commissions.

The next week, the company reports disappointing earnings and the stock drops 50%.

The position is now worth 10,000, but you still owe that much to the broker for the margin loan.

In that scenario, you would have lost all of your money plus interest and commissions.

So don't invest on margin, especially being aggressive in one sector like I did in 1999 during the tech boom.

Peter Lynch once said, when you have a family in a house, and the market is going down, and you're on margin, it's probably too much pressure for you to do the right research and the right kind of thinking to make good decisions.

Today, I look at margin debt levels on a weekly basis.

Investors Business Daily reports this on their subscription-based service, and it shows the year-over-year percentage change in margin debt levels.

And this has been a good indicator of exuberance in the past and has actually flagged three of the major market tops since the 1970s.

It's not a foolproof system, but anytime that margin debt level percentage change year-over-year gets above 55%, it's usually a pretty good indicator of a market top.

We're not quite there yet, but margin debt levels as of today are about 22% from a year ago.

So in conclusion, a wise wealth tip, you've heard it a variety of times through this podcast, but leverage is not your way to create wealth.

I know it can feel like, wow, I can borrow more money to buy stocks, I can increase my returns, I can increase my wealth, but it's the great destroyer of wealth.

I would be a lot wealthier today if I would have just bought quality stocks and hung on to them and never borrowed money to buy stocks.

But if you do borrow money to buy stocks from your portfolio, never use more than 10% of your collateral and make sure the base of stocks you're borrowing against are solid blue chip companies, not all in one sector.

And if you borrow money on a short-term basis to pay off a loan or a credit card, margin rates are a little higher today because of interest rates, but make sure you have a plan to pay that off in three to six months.

So that's it for today's episode, Wealth Decision Number Eight.

Don't borrow money to buy stocks.

If you'd like to schedule a discovery call with me, you can go to my website at momentouswealthadvisors.com and I'll spend some time to get to know you a little bit and find out if I might be able to steer you in the right direction or help you with your financial future.

Listen to this episode on Apple Podcasts or Spotify


-Brian D. Muller, AAMS® Founder, Wealth Advisor

Momentous Wealth Advisors in a fee-only fiduciary advisory firm

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