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Warren Buffett has spent most of his lifetime making money on equity investments. You would think after decades of success, he’d have the confidence to buy stocks with borrowed money. After all, investing with borrowed money is a common strategy for amplifying gains.
There are hundreds of leveraged exchange-traded funds (ETFs) on the U.S. stock exchange, for example. These ETFs attempt to double or triple the daily returns of an underlying index by using debt and financial derivatives.
Individual investors are in the leveraged game as well. One Yahoo Finance-Harris poll suggests that 10% of investors have borrowed money from their brokers to buy stocks.
And yet Buffett, one of the world’s most successful investors, says borrowing to invest is a risk he’s not willing to take — not even when the market’s down and the buying opportunities are plentiful. Here are the basics of investing with debt and why Buffett thinks it’s such a bad idea.
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Buying on margin is the usual way to borrow money for investing. When you buy on margin, you take a loan from your broker, who is happy to comply because the marginable securities in your investment account will collateralize the loan.
Under Securities and Exchange Commission (SEC) rules, you can pay for up to 50% of a stock purchase this way. You would cover the other 50% with your own money.
The SEC also mandates a minimum maintenance margin of 25%. This means your equity must be 25% or more of your account value. Equity is the value of your investments less your loan balance. Many brokers enforce higher maintenance margins of 30% or 40%.
If a down market pushes your equity value below the maintenance margin requirement, you must deposit money or sell assets to restore your equity cushion. This is the dreaded margin call. If you don’t comply, your broker will sell your stocks to get your account back in compliance.
Buying stocks on margin amplifies your gains and your losses. Here’s a simplified example. Say you borrow $10,000 to buy $20,000 in stocks. If those stocks appreciate 25%, you’ve made $5,000 on your initial $10,000. Not counting the interest on your loan, that’s a 50% gain. Had you paid cash for the stocks, your gain would be 25% — or $5,000 on the $20,000 outlay.
A similar thing happens with losses. Starting with the same stock buy, a 25% decline creates a 50% loss if you financed half the purchase. If you’d paid in cash, your loss on the same transaction is only 25%.
In Buffett’s view, the upside of borrowing to invest isn’t worth the risk. His concern is the potential for stocks to drop dramatically without warning. This is tough enough on investors who can choose to ride out the downturn.
But downturns are infinitely more taxing if you have margin debt. You end up watching share prices fall and wondering when your broker will force you to sell.
Buffett explained the risk this way in a 2017 letter to Berkshire Hathaway shareholders:
There is simply no telling how far stocks can fall in a short period. Even if your borrowings are small and your positions aren’t immediately threatened by the plunging market, your mind may well become rattled by scary headlines and breathless commentary. And an unsettled mind will not make good decisions.
In other words, if the margin call doesn’t wipe you out, poor decisions might.
Buffett has also said, “It’s insane to risk what you have for something you don’t need.” Buying on margin falls into that category of behavior. Yes, you can double your potential gain. But that’s impossible to do without also doubling your loss potential. And if a well-funded billionaire investor won’t make that trade-off, most individual investors probably shouldn’t, either.
Catherine Brock has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Berkshire Hathaway (B shares). The Motley Fool recommends the following options: long January 2023 $200 calls on Berkshire Hathaway (B shares), short January 2023 $200 puts on Berkshire Hathaway (B shares), and short January 2023 $265 calls on Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.
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