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The risks of buying mark to market investments on margin

This is part of my series on why borrowing to invest is usually a bad idea.

A mark to market investment is one where the price of a security (or a company or other recently valued asset) gives an accurate appraisal of its current financial worth.

For instance, a company’s share price tells you what buyers are prepared to pay for it right now. We can call this the market price.

The company may own assets in excess of the value implied by its share price, but the company’s valuation is marked to market by what traders are currently willing to pay for its shares.

Value investing involves looking for assets that are worth more than their market price. It requires patience, because it can take time for value to be ‘outed’ – that is, for the market price to tally with the company’s true value.

Mark to market, mortgages, and borrowing to invest

One reason why using a mortgage offers the best hope of making the maths work if you borrow to invest is because mortgages are the cheapest form of debt.

But another key advantage of a mortgage is that your house and your debt is not marked to market.

This means that if the Daily Mail reports house prices have fallen by 10%, you won’t be expected to stump up an extra £30,000 by your bank.

i.e. You won’t face a margin call to avoid being kicked out of your house just because your house’s price has fallen while your debt is unchanged. Negative equity only matters if you need to sell and you can’t repay your mortgage.

If you have a mortgage while investing in equities then you are effectively borrowing to invest, because the money you use to buy shares could instead be used to pay off your mortgage.

Most of us do this, if only because we have pensions. We get away with it because any declines in our share portfolios don’t force a margin call on the mortgage on our homes.

Indeed, some people go a step further by using an interest only mortgage to try to invest their way to repaying the capital they owe their bank. This is much riskier, as there’s no guarantee their investment will grow sufficiently large to cover the outstanding capital payment on the house at the end of 25 years.

Mark to market and spreadbetting

In contrast to a mortgage, a spreadbet is a good example of a mark to market loan that can be extremely expensive if you can’t meet the margin calls, let alone all the other magnified risks of investing with borrowed money.

With a spreadbet, you put down say a 20% deposit to trade a particular share on margin. The other 80% of your holding is bought via a loan. (The interest cost is wrapped up in the ‘spread’).

For example, let’s say you want to take out a £1,000 position in a share via a spreadbet. You put down £200 (20% of £1,000) as you place your bet.

Now imagine the share price drops 10%. Your position is now worth £900 — and you’ve lost £100.

You will therefore face a margin call to maintain your 20% deposit ratio, which means the spreadbetting company will immediately ask you to add extra money to top up your position.

In this case you’d need to add £80 to get to £180 (20% of £900) to stay invested.

Given how volatile equities are, such mark to market factors can easily kill your bet. You will either face a margin call or be kicked out of your investment when prices fall, and if you do sell then you’ll likely be too slow or scared to get back in before prices rise again.

Equities are too volatile for short-term borrowed money

When you borrow to invest on margin, you are at the mercy of the short-term. Yet the volatility of equities can only be tamed by taking a long-term view.

Spreadbetting is therefore risky not only because you are borrowing to invest and might lose money you don’t have, but also because mark to market can shake you out of positions that go against you in the short-term, even if your long-term call is good.

No wonder more than 80% of spreadbetters lose money.

We discussed above how your bank won’t bother you if property prices fall provided that you keep paying your mortgage.

That your bank doesn’t think it’s worth the risk to give you the same terms to invest in equities should set alarm bells ringing about the wisdom of borrowing to invest!

Footnote on spreadbetting

It is possible to spreadbet in shares fairly safely, if you reduce or entirely avoid leverage (debt) by offsetting your spreadbet portfolio with an appropriately sized cash savings account. You might do this to avoid Capital Gains Tax, for instance. It’s a fiddly subject, though, and one that will require an article in its own right. Watch this space!

Series NavigationYou can’t bank on an expected returnWhy it’s almost always a bad time to borrow to invest

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{ 5 comments… add one }
  • 1 ermine July 13, 2010, 11:57 am

    > This is much riskier, as there’s no guarantee their investment will grow sufficiently large to cover the outstanding capital payment on the house at the end of 25 years.

    remember with-profits endowments, and the associated scandal…
    ISA mortgages…

    repayment is the only sure way to won the house at the end, and that only if you stay employed for most fo the 25 years. It’s easy for a starry-eyed late 20’s or early 30 year old to be blinded by empty promises, and you probably haven’t got the wisdom to be able to qualify good investments at that time, it takes experience.

    Present company excepted, but you’re not that starry-eyed youth. And the tragedy is that this warning won’t help people. My parents warned me against endowments. My colleagues warned me against buying at the top of the Lawson boom. And I still went for it like a crazy fool 🙂 The siren-song of UK house ownership does that to our young people…
    .-= ermine on: Why You Shouldn’t Buy a House =-.

  • 2 DreamSpark @ Thunderdrake July 15, 2010, 7:25 pm

    Borrowing on margin is usually a horrible idea. Especially if the interest rates are high. The only exception to this I can think of is for A) starting a company or business or B) investing in real estate. Investing in anything else… It’s just ridiculous. You got the chains of bondage threatening to go around your neck. It just isn’t something worth sleeping at night to – the whole point of investing to begin with. Sleeping peacefully.
    .-= DreamSpark @ Thunderdrake on: 7 Reasons why I HATE mutual funds =-.

  • 3 Andy July 20, 2010, 1:03 pm

    well, this definitely doesn’t hold true with with today’s ultra-low interest rates – a £20,000 spread bet position on Vodafone may only cost up to £440 in financing charges to hold over a twelve month period!!

  • 4 The Investor July 20, 2010, 1:41 pm

    @Andy – I haven’t looked at the effective interest rates charged by spreadbetting firms for a while, but 2% doesn’t seem unreasonable, no.

    It doesn’t get around the main problem of leverage and marked-to-market investments though, which is volatility. I appreciate spreadbetters will say there’s a range of stops and other trading techniques that can mitigate that sort of thing or make volatility profitable for the trader but I’m skeptical given the appallingly large majority of spreadbetters who lose money.

  • 5 The Investor July 22, 2010, 6:39 pm

    @Aury – I couldn’t agree more about sleeping soundly. It’s a reason enough to avoid all forms of debt – even a mortgage, perhaps, despite the excellent returns from gearing up to buy property over the past 70 years for most people.

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