Equity Management #17 : More random thoughts on margin investing.

Here's an update.

This week on Wednesday the kind folks of Maybank Kim Eng bought me and two other finance bloggers to lunch to apologise for the margin call made on my account.

( As I was the only guy who got margin called, I accused the other bloggers of getting a free meal out of my misery ! )

The lunch was somewhat hipsterish -  we ate octopus at this place called Venue by Sebastian. The highlight of the session if not so much the free food but just how surprisingly insightful the folks of Maybank are.

I always thought that most of the finance folks you meet in the industry are the run of the mill guys who can spout finance after passing a few CMFAS exams.  It takes personal effort to read finance literature and even very "smart" guys who claim to be in the know will just talk about about becoming the next Warren Buffett. It was a really enlightening meal.

This article shares some random thoughts about margin investing :

a) Brokerage firms can't promote margin investing as much as they'd like.

I learnt that actually our local regulators are quite wise and proactive in preventing the promoting of margin trading because it induces folks buy stocks that they can't afford. We agreed that this point that this is a good idea because the traditional idea behind margin investing is to buy penny stocks and magnify capital gains.

Only a small minority will use margin trading to magnify yields and minimise trades. It's almost up to us financial bloggers to talk about responsible leverage investing without any inducement from corporate firms.

b) Lifecycle Investing by Ian Ayres and Barry Nalebuff

This was the clincher that convinced me that there are seriously smart folks in Maybank Kim Eng.

Their staff mentioned this book which I read quite a while ago about why, for younger folks, it may be wiser to use some amount of leverage to magnify stock market returns. The book is mathematically rigourous in their approach but it was unable to induce me into action then because I still felt that it was safer to reach financial independence first before even thinking about looking at margins.

I strongly suggest that readers consider reading this book before even getting into margin trading to understand that a more deliberate approach to magnifying gains can be designed to speed up your journey into financial freedom. I'm going to see if there is a way to squeeze this book into my next talk in July.

c) Some preliminary numbers on the risk of default.

I was digging up some of my previous backtest results from the talks I gave last year and found that for most of my dividend screens, whether they are for dividend stocks or REITs, I am looking at a standard deviation of around 12% after a decade long backtest (I use the square root of semivariance). So if you project a return of 9%, a 2-standard deviation event will set you back around -15% and this has a probability of around 2.5% of happening. My backtest for dividend stocks in 2016 had annual returns of 17%.

So this is a strong case for my margin ratio of 200% as I will need a massive drop of 30% to trigger a margin call, this is mathematically expected to occur in less than 1 out of 40 years.

Of course, I just need to beware of the fat tails that I've not been able to mathematically model. Unless you are Nicholas Taleb and have your own prime broker, you are not likely to survive a Black Swan event anyway.

d) Mental accounting and margin trading account.

Investment Moats asked me why don't I just have a unified trading account with a margin facility. I replied that its because I have a mental accounting bias.

In this case, it is justified because Maybank can offer 2.88% interest on 200% leverage so I have to go through the process of opening a new account. I just met an old friend today who claimed that if I go with him on DBS Treasures, I might be able to get financing at merely 1.6% but I can only leverage up to an additional 50%-70%. I guess different providers will come up with a different scheme to attract investors.

At the end of the day, a margin trading account is aspirational and you should not be trying to pay off your basic expenses using leverage. A portfolio that pays the bills should not employ leverage.

For now, I doubt I would recommend that anyone start margin trading without a portfolio backing them up that is ten times the size of the margin account.