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Are Margin Loans Risky?
CS journalists
While borrowing to invest can accelerate your investment returns, it increases your exposure to investments that can also decrease in value. Margin lending therefore magnifies the potential for both gains and losses.
When share prices stay flat for a period of time, investors who have bought on margin traditionally have had two choices:
(a) ride out this period, and continue to hold your shares in the hope that they will rise in the longer term. In this case, interest costs are still being incurred, and you rely on dividends paid on the underlying shares to reduce your holding costs.
(b) sell your shares.
The danger is if the market plunges you could receive a margin call and be forced to sell shares at the worst possible time, or be asked to add extra security by way of cash or unencumbered shares.
What is a Margin Call?
Lenders want to be sure that the value of an investment portfolio well and truly covers the amount borrowed to finance it. When the value of your portfolio drops too close to the value of your loan, the lender may step in and make a 'margin call'. You would then need to restore this 'buffer zone' by :
(a) injecting more cash to lower the borrowed amount
(b) buying more shares to raise the portfolio's value
(c) selling some of the existing portfolio to raise cash to lower the loan amount
If a security decreases in value, the investor may also need to provide additional funds or pay down the loan so that it is no more than the maximum security ratio. This is called a margin call.
A margin call is made by the bank when a customer's portfolio has fallen in value to a point where the loan makes up more than about 70 to 80 per cent of the entire portfolio.
A margin call requires the customer to reduce their loan by either selling shares or topping up with cash. If the customer does neither, the margin lender will sell shares as required to bring the loan back into order.
The average investor operates at 50 per cent. That is half of their portfolio is their own equity and half is the bank loan. The average investor has an outstanding loan of $130,000 and of all funds invested, about 70 per cent is in direct equities, about 25 per cent is in managed funds.
There are a number of ways to minimise the likelihood of a margin call:
(a) Don't use all your available funds ie gear yourself to 50% not to 80%. In this case the value of the portfolio would need to fall by 30% for you to receive a margin call.
(b) Diversify across different sectors. A portfolio might consist of industrials, banks, telecommunication and possibly resources. A diversified portfolio enhances the ability to balance exposure over various sectors.
(c) Stick to your original strategy and evaluate your portfolio regularly.
The responsibility for the management of your portfolio ultimately rests solely with you, the investor. It's up to you to keep you margin lending account in order at all times. The lender will use its best endeavours to contact you if needed, but final responsibility remains with you.
You can minimise the risk of this happening by keeping a low loan-to-valuation ratio, by keeping spare cash in the bank or by using a home equity loan. Just be aware it's a long-term strategy, so don't panic when the market has one of its inevitable downturns.
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