When people discuss margin loans they inevitably refer to margin calls, but Julie McKay writes that a good understanding of the system can help investors navigate the challenges.
Related: A margin loan is still a loan
Whenever a margin loan is mentioned, the first objection raised is the margin call. There is no doubt some geared investors suffered serious financial consequences from the global financial crisis (GFC) and resulting margin calls.
But let’s keep this in perspective.
At the height of the GFC (December 2008), 4 per cent of accounts received a margin call. In more normal market conditions, a margin call is triggered on less than 1 per cent of accounts on average.
In other words, the majority of geared investors have never received a margin call. But trying to convince investors (at least those who use gearing prudently) that the chance of a margin call is low misses the point.
The underlying issue is inherent investor behavioural biases - investors typically dislike crystallising losses, are prone to hindsight bias and may have a set and forget mentality.
These natural instincts can cause any investment strategy, whether geared or not, to come unstuck.
A margin call is simply an urgent demand by the lender for the investor to reduce their gearing ratio to an acceptable level.
To understand the ‘acceptable gearing level’, let’s briefly recap gearing ratio, loan-to-value ratio (LVR) and buffer.
An investor’s gearing ratio is the ratio of the amount borrowed to the value of the collateral for the loan. For example, if you borrow $40 to buy an asset worth $100, then your gearing ratio is 40 per cent ($40 loan divided by $100 asset).
The gearing ratio an investor adopts depends on their personal circumstances, financial goals, interest rates and market expectations.
But generally, prudent investors are moderately geared (gearing ratio of 50 per cent for example) over a diversified, moderate volatility portfolio.
An LVR is the maximum the bank will lend against a particular investment. A typical LVR is 75 per cent. So for an asset worth $100, an investor can borrow up to $75. Unfortunately, LVR is often used to also mean gearing ratio which can be confusing.
The value of most financial investments continuously changes. To avoid triggering a margin call for every small market fluctuation, a margin call is only triggered when the gearing ratio exceeds the LVR plus buffer.
For example, if the LVR is 75 per cent and the buffer is 10 per cent, a margin call is triggered if the investor’s gearing ratio exceeds 85 per cent.
If a margin call is triggered, the investor must quickly (usually within 24 hours) reduce their gearing ratio to less than or equal to the LVR - typically by selling investments or reducing the loan using other reserves.
Closing your eyes won’t help
Persistently falling investment value (which causes the gearing ratio to rise) should be a trigger for a strategy reassessment.
Many an unlucky investor has ridden markets down, with fingers crossed for a bounce, rather than cut their losses and switch to another strategy. Prudent investors have an exit strategy.
A margin loan is typically suited to someone with medium to long-term financial goals. Unfortunately these investors tend towards a set-and-forget mentality - or at best an annual review. The old adage, “its time in the market not timing the market”, remains important.
But it’s equally true that investors shouldn’t ignore clear market signals, such as persistent or unexpected falls (or increases) in investment value. This is particularly true for a geared strategy, which magnifies gains and losses.
Unfortunately, many investors (both geared and non-geared) do not set investment strategy reassessment triggers aside from calendar reviews. Further, investors are often not prepared for the hard decision to sell a losing investment.
Look for dips, but don’t forget the plan
Some argue that selling when the market is falling is the wrong strategy. Investors should “buy the dip”. This argument suffers from hindsight bias - it’s a rare investor who has the power to accurately predict the market.
It is equally useful to argue (and suffers from the same need to consult a crystal ball), that the investor should sell, wait until the market drops further and then buy back the investment.
With the benefit of hindsight, an investor who sold on 30 June 2008 for example, whether because of a margin call or as part of a portfolio review, would be happier than someone who remained in the market throughout the GFC.
This hindsight bias argument also ignores the investor’s existing circumstances. If an investor is underweight their target exposure to a particular asset class, then the bottom of the market cycle is obviously the ideal time to buy (assuming someone can pick the market turn).
But if an investor’s portfolio, whether geared or un-geared already includes the recommended weight of (or is overweight) an asset class, then buying more (even if on a known market dip) goes against their strategy.
A strategy reassessment may be a sensible response to a significant market change, and short-term opportunities don’t need to be ignored.
But changing strategy on the fly, without considering goals and market expectations, is the undoing of many an investor.
Discipline is key
Successful investors are disciplined. Their investment strategy is aligned to their goals and includes “‘goldilocks” stop-loss and stop-profit review triggers - not so tight that there is excessive trading but not so wide that significant market changes are overlooked.
They recognise that natural human biases are often the enemy of profitable investing. Markets can gap leaving investors with no time react and adjust their strategy.
These are exactly the market circumstances when prudent investors hope the margin lender has the expertise to quickly execute the last resort margin call.
Julie McKay is the senior manager, technical and research at Leveraged Equities.