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You’re Going to Receive a Margin Call

Say you have 100% of your brokerage account in a diversified portfolio of stocks. And you’re absolutely certain that the market is going to rise.

Sounds great, right? But if you’re like most investors, you want to get rich as soon as possible.

If the market cooperates and blasts higher from here, you want to be sure that you’ve maximized your gains when your investments rise.

Unsurprisingly, the financial services industry has a way to help you satisfy this greedy impulse… It’s called margin debt.

Leveraging America

As if mortgages, auto loans and credit card debt weren’t enough, we can lever up our brokerage accounts, too.

Margin debt is basically a securitized loan from your broker.

The securities that you’ve already bought are used as collateral, and your broker gives you additional buying power. Your broker also charges you interest on what you’ve borrowed.

Of course, leverage magnifies both gains and losses. But it allows you to buy quantities of stocks that you otherwise couldn’t afford.

And retail investors have borrowed a tremendous amount of money to do just that…

New York Stock Exchange (NYSE) member organizations are required to report the aggregate amount borrowed by their customers to purchase securities. And although not every investor has borrowed to juice returns, the aggregate amount across all accounts is pretty shocking.

In January, total NYSE margin debt reached a record $451 billion. To put this figure into perspective, margin debt peaked in 2000 and 2007 at around $280 billion and $380 billion, respectively.

Granted, these dollar figures aren’t directly analogous, due to inflation and growth in household financial assets.

But we can arrive at more comparable figures by deducting total margin debt from aggregate cash in brokerage accounts to get a sense of “excess cash.”

Now, I’m not suggesting that the stock market is imminently going to crash and melt our faces off.

However, it does mean that many investors are playing with fire in their brokerage accounts.

Allow me to propose a different course of action… Leave it up to professional asset managers.

Professional Driver… Don’t Attempt Yourself

I recently highlighted two closed-end funds that both employ leverage – the DoubleLine Income Solutions Fund (DSL) and the Flaherty & Crumrine Dynamic Preferred & Income Fund (DFP).

So with these funds, you can reap the rewards of leverage, without taking on undue risk.

Plus, one of the benefits of the closed-end fund structure is that the asset managers won’t have to liquidate holdings to meet redemptions. This is what normally happens to mutual funds (open-end funds) during times of financial market stress.

It’s also what would happen in your personal account if the value of the securities you hold falls sufficiently low. Your broker would issue a margin call, and you would either have to liquidate a portion of your holdings or deposit more cash into your account.

This is one of the reasons why many people are unable to buy low and sell high. They are actually forced by their brokerage firm to sell when the market suffers a serious decline.

Don’t let this happen to you.

Bottom line: It’s better to let professional asset managers take on leverage than to do it yourself in your retail brokerage account.

Safe (and high-yield) investing,

Alan Gula, CFA