Warren Buffett doesn’t borrow money to buy stocks, and neither should you
Warren Buffett has spent most of his life making money from stock investments. You would think that after decades of success, he would 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 American 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 also in the leverage game. A Yahoo Finance-Harris poll suggests that 10% of investors have borrowed money from their brokers to buy stocks.
And even Buffet, one of the world’s most successful investors, says borrowing to invest is a risk he’s not willing to take, even when the market is down and buying opportunities are plentiful. Here are the basics of debt investing and why Buffett thinks it’s such a bad idea.
Buying on Margin 101
Buy on margin is the usual way to borrow money to invest. When you buy on margin, you take out a loan from your broker, who will be happy to comply because the margin securities in your investment account will guarantee the loan.
Under Securities and Exchange Commission (SEC) rules, you can pay up to 50% of a stock purchase this way. You would cover the remaining 50% with your own money.
The SEC also mandates a minimum maintenance margin of 25%. This means that your equity must be 25% or more of your account value. Equity is the value of your investments minus your loan balance. Many brokers apply higher maintenance margins of 30% or 40%.
If a bear market pushes the value of your equity below the maintenance margin requirement, you must deposit cash or sell assets to restore your equity cushion. It’s the dreaded margin call. If you do not comply, your broker will sell your shares to bring your account into compliance.
Amplified Gains and Losses
Buy stocks on margin magnifies your wins and losses. Here is a simplified example. Let’s say you borrow $10,000 to buy $20,000 worth of stock. If those stocks appreciate by 25%, you have earned $5,000 on your initial $10,000. Not counting the interest on your loan, that’s a 50% gain. If you had paid cash for the shares, your gain would have been 25%, or $5,000 on the $20,000 expense.
A similar thing happens with losses. From the same stock purchase, a 25% drop creates a 50% loss if you financed half of the purchase. If you had paid in cash, your loss on the same trade is only 25%.
Buffett’s take on margin debt
In Buffett’s view, the benefit of borrowing to invest is not worth the risk. His concern is the potential for stocks fall dramatically without warning. It’s quite difficult for investors who can choose to ride out the downturn.
But downturns are infinitely more taxing if you have margin debt. You end up watching stock 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:
It’s just unclear how far the stocks can drop in a short period of time. Even if your borrowings are low and your positions aren’t immediately threatened by a falling market, your mind may well be rattled by chilling headlines and breathless commentary. And an unstable mind will not make good decisions.
In other words, if margin call doesn’t kill you, bad decisions might.
Don’t risk what you have
Buffett also said, “It’s foolish to risk what you have for something you don’t need.” Buying on margin falls into this category of behavior. Yes, you can double your potential gain. But that’s impossible to do without also doubling your downside potential. And if a well-funded billionaire investor doesn’t make that trade-off, most individual investors probably shouldn’t either.
Catherine Broc has no position in the stocks mentioned. The Motley Fool holds positions and recommends Berkshire Hathaway (B shares). The Motley Fool recommends the following options: $200 long calls in January 2023 on Berkshire Hathaway (B shares), $200 short puts in January 2023 on Berkshire Hathaway (B shares) and short calls of $265 in January 2023 on Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.