Clients trust their financial advising team to offer guidance tailored to their needs and goals. That team can also provide a critical historical perspective when clients are considering different investment options which may not align with their goals or their long-term best interests.
An example of this is the idea of margin, where investors use existing investments as collateral to purchase more securities than their readily available cash allows. For example, someone wants to buy $2 million of a stock they think will increase in value, but they only have $1 million of cash. That person can ask their brokerage firm to loan them an additional $1 million. Assuming their financial statements align with the firm’s margin policies, they could fund the remaining $1 million on margin to buy the additional shares of stock, like a line of credit.
If the stock grows in value, the investor’s overall return is magnified because they are earning on both their own funds and the funds borrowed from their investment firm. After taxes, the investor pockets the profit and pays off the loan. The firm gets its money back, plus interest on the money they lent to the investor. This is a scenario where everyone walks away happy.
But investments can also decrease in value. If that same stock drops 75% in value, that $2 million investment is now only worth $500,000. If the stock drops enough to trigger a margin call, the investor could be forced to sell at a loss. This could result in the investor not only losing all of their own funds, but also unable to pay back the margin owed to their investment firm. In an extreme scenario, this could lead to bankruptcy if you can’t pay off the loan and interest. If several investors face margin calls simultaneously, this can sometimes trigger a broader market downturn.
According to the latest FINRA data, margin debt reached a record $1.06 trillion, up 32.9% from a year ago. Buying stocks on margin is most commonly used by someone trying to invest in high-risk, short-term holds with stocks they think will go up substantially in value. If a client’s goals do not align with this kind of strategy, then it should be eliminated from consideration and not recommended.
It can be easy to focus on someone who built their wealth from shares of Apple stock bought in 1980 and forget that was over 40 years ago. That’s not about getting rich quickly. That’s about growing your wealth over time. And while Apple is a success story, there’s a graveyard of tech companies that didn’t make it. Apple itself came close to closing its doors on several occasions.
Sometimes, reminding people of these historical facts is not an enjoyable part of my practice. But I believe it is a financial adviser’s duty to tell people what they need to hear, not necessarily what they want to hear. Short-term investing brings an elevated level of risk because it can be more susceptible to wider price swings that can be amplified in a volatile economic climate by unexpected shifts in corporate earnings, jobs reports, trade policy or other variables that no one may be thinking about.
Partnering with a financial advising team that prioritizes the client’s needs and goals can make all the difference. That’s not to say any form of trading with margin is bad. The more relevant question to answer is whether or not the use of margin is appropriate for that particular client’s situation.
Editor’s note: Ben McLintock is senior vice president and senior wealth advisor with Arvest Wealth Management. The opinions expressed are those of the author.