Cutting Back on Risk

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Markets returning to rationality

I make no secret of the fact I am anti-debt; specifically, I carry none. That’s right, no credit card debt, no personal loans no mortgage. During

MY CAREER IN INVESTMENT BANKING

I discovered a winning formula to build wealth: avoid debt and invest in dividend paying stocks. Net of tax, these securities generate more money than needed to live on. I either reinvest this monthly cash flow into additional dividend paying stocks, or divert the funds to buy rental properties. It’s a system that has built wealth for me, it’s easy to undertake and is an approach I encourage everybody to follow. The problem is

BUILDING WEALTH IS A LONG TERM GAME

one that many try to accelerate, by finding a “system”, a “tip service” or a “guru”, anything to get rich quickly. Take it from a veteran of Global Wall Street: it ain’t gonna happen. Building wealth takes time, but unfortunately many new to the markets seize upon a technique called

BUYING SHARES ON MARGIN

or borrowed money. Known as margin debt, this allows equity market participants to take a short term loan, collateralised by assets they hold in their brokerage accounts. Also called leverage, depending upon the shares purchased, roughly 50% of total value may be borrowed. Effectively, participants can double their investment capital — and potentially profits — using margin. But while buying shares on margin can increase profits, leverage works in both directions and it can also magnify losses. In The United States,

THE FINANCIAL INDUSTRY REGULATORY

Authority, (FINRA), defines rules followed by brokers and, ultimately, customers of a brokerage. As part of their mandate, FINRA reports Margin Debt monthly, a metric which is closely watch by many market participants, myself included. The chart below show margin debt for the last ten years

FINRA Margin Debt, 2012 to 2022, source yCharts, Author, 2022

ACROSS THE HORIZON MARGIN DEBT

increased gradually, until the pandemic. At that point, a very large number of people “discovered” stocks and began to engage the market. Many, frustrated by what they viewed as inadequate gains on their capital (i.e., not getting rich fast enough), leveraged up by using margin debt. The unprecedented scale of new margin debt taken on caused significant concern in industry. In 2020 we learned that

ROUGHLY 43% OF RETAIL CUSTOMERS

used margin for their trading. At the same time, about half of these customers attempted to time the market. In other words, they bought and sold securities rapidly, almost always intraday, in an attempt to profit from short term changes in share prices. Sadly, we know an overwhelming majority of retail traders lost money when they engaged in aggressive tactics such as acquiring shares on margin. We also know significant numbers of retail market participants were damaged financially, some to the point of bankruptcy, when leveraged positions moved against them. We monitor margin debt

FOR SIGNS OF MARKET IRRATIONALITY

and in 2021 we saw margin debt, as a percentage of GDP hit a historic 3.9% in 2021. Retail brokerage customers were taking on an excessive amount of debt; in other words, acting in an irrational manner. But over the last eighteen months

WE HAVE SEEN MARGIN DEBT TO GDP

fall to a level roughly in line with the low run average of 2.8%.

In other words, this metric suggests rationality is returning to the market.

It’s about time.

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