There are some people out there with eye-popping returns of greater than 20% a year. While this looks amazing compared to the historical 10% return of the S&P 500, the comparison might not be entirely fair if the person used financial leverage to boost returns. Trying to copy the same strategy can lead to financial ruin.
Financial leverage is when a person or company borrows money to invest in the hopes of generating higher returns. For most investors, this comes in the form of a margin account that lets investors borrow funds from their broker to buy stocks. The accounts require a minimum amount of cash or equity to maintain before the broker starts to sell your stocks to pay for the loan.
Leverage with Regulation T Margin
Here’s a hypothetical example of how a margin account works under regulation T.
An investor with a $10,000 portfolio borrows another $10,000 for a total of $20,000. This is the maximum allowed under regulation T where at least 50% of the initial purchase must come from the investor.
The investor chooses to use all the money to buy a stock that is currently at $10.00 a share and ends up with 2,000 shares.
If the stock goes to $12, the total value becomes $24,000. The investor pays back the borrowed $10,000 with interest of let’s say $500 and keeps $13,500. That’s a 35% return with the use of margin. Without the use of margin, the investor would have a 20% return instead.
But, leverage also works the other way around.
If the stock went to $8 instead, the total value becomes $16,000. The investor is left with $5,500 after paying back the original loan of $10,000 and $500 in interest. A large 45% loss.
Even worse, if the stock falls too far, the broker will initiate a margin call and demand the investor transfer more funds into the portfolio to cover the loan. If the investor had other stocks in the portfolio, the broker would also be able to sell those stocks without consulting the investor first to meet the maintenance requirements for the margin loan.
Don’t get enticed by margin
More than the entire portfolio can be lost with margin accounts and brokers can set their own requirements that are more stringent than what is allowed under regulation T. The potential returns from borrowed funds might look enticing, but when things go wrong, it can be disastrous. The person with a 20%+ return might be a great investor, but check to see if they are using any leverage to achieve those results. Their portfolio may not be a good benchmark against someone who doesn’t use any leverage.