“Deciding what not to do is as important as deciding what to do.”
– Apple co-founder Steve Jobs
Investing is made easier if you recognize you can ignore strategies that don’t fit into your long-term plan, such as those that involve high-risk speculation and most that use leverage.
A mechanical lever, as you may remember from science classes, makes it possible to use less effort to move more weight. In a similar way, financial leverage uses a relatively small amount of money to control the rights to a more valuable asset. (A form of leverage familiar to most of us is a home mortgage. Your down payment gives you control of an asset worth much more than what you put down.)
In investing, the alluring thing about leveraging is that gains are magnified. However, so are losses. Unless you’re prepared to suffer potentially large losses, you would be well advised to avoid the following three speculative strategies.
This strategy — which tends to grow in popularity when markets are rising and investor confidence is strong — involves borrowing a portion of the money needed to buy securities. (Margin debt currently is at an all-time high, exceeding even the levels that occurred in the heady days leading up to the dot-com crash of the late 1990s and in the period just before the financial crisis of 2008.)
Here’s how margin works. Suppose you want to take a substantial position in a stock but don’t have enough cash. Your broker will lend you up to half of the purchase price, with the shares you buy with your own money acting as collateral for the loan. So, for example, you could buy stock worth $20,000 by putting up $10,000 and borrowing the other $10,000. If the stock’s value rises to, say, $28,000 and you sell at that point, you’d pay your broker the $10,000 you borrowed (plus interest and commissions — we’ll assume $1,000), leaving you with $17,000 — or a 70% gain on your original $10,000 investment!
Now a less-happy scenario. Instead of rising, the market value of your stock drops from $20,000 to $16,000 and you have to sell. After repaying your broker $10,000, plus $1,000 for interest and commissions, you’d be left with only $5,000 of your original $10,000 investment. In percentage terms, your loss would be 50%. Ouch.
Could your stock fall so far in value that, even after selling it, the proceeds wouldn’t be enough to repay your broker? Not likely, because before things got that bad, you’d get a message from your broker (the dreaded “margin call”) reminding you that government regulations require you to maintain a margin amount equal to at least 25% of the market value of the investment. (Some companies require even higher margin percentages.)
Let’s say the value of the stock drops all the way to $12,000. The maintenance-margin requirement is 25%, so you are required to keep a margin of at least $3,000 (i.e., 25% of $12,000). Since $10,000 of the remaining investment is collateral against your loan, your equity position has shrunk to only $2,000. You’d have to deposit another $1,000 to meet the requirement.
At this point, the stark choice you face is either to make the required deposit and continue to hold the stock, or sell the position, pay back the loan, and take your loss. If you fail to act promptly, your broker will either sell enough of your shares to raise the money needed to bring your margin into compliance, or liquidate your account and reclaim the amount you borrowed.
- Commodity Futures
These are contracts investors enter into now for transactions that will take place later. If you’ve ever bought or sold a house, you’ve entered into a transaction similar to a futures contract. You agreed on: (1) the quantity and quality (one house in such and such condition), (2) the price, and (3) the date when the house will be “delivered” (the closing date).
Commodity futures were devised to protect farmers and food processors from the unpredictable nature of the agricultural marketplace. Farmers could lock in a guaranteed price for their product — thus avoiding concerns about prices falling — while processors gained protection against possible price spikes. By agreeing ahead of time on the quantity, quality, and price, as well as setting the date the crops (or livestock) would be delivered, both parties could plan with greater confidence.
To guarantee that neither party would renege, each would make a good-faith deposit of 5%-10% of the agreed-upon value of the transaction.
Eventually, commodity futures expanded beyond actual sellers and buyers seeking protection against the vagaries of agricultural prices. Today, the futures market includes many speculators who trade futures contracts — related to agriculture, energy, natural resources, and metals—yet never actually deliver, or take delivery, of a commodity.
Futures trading typically is done through online brokers that specialize in that area, such as optionsXpress (part of Charles Schwab), TradeStation, and OptionsHouse. TD Ameritrade also has a futures-trading platform. To be approved for trading, an investor must provide a broker with several pieces of information (required by government regulations), including age, income, net worth, and details about previous investment and futures trading experience.
The inherent price volatility of commodities and the highly leveraged nature of futures contracts combine to make this kind of trading emotionally wrenching. The potential exists for a large loss or a remarkable return in a short amount of time. And, importantly, commodity traders can lose much more than they invest. As the old saying goes, “The way to make a quick million in the futures market is to start with two million.”
Unless you have enough cash on hand to cover any losses, one other consideration — from a biblical perspective — is that investing in commodity futures may involve presuming on the future (“Come now, you who say, ‘Today or tomorrow we will go into such and such a town and spend a year there and trade and make a profit’ — yet you do not know what tomorrow will bring” James 4:13-1, ESV).
Average investors who wish to gain exposure to commodities are better served by investing in commodity-based exchange-traded funds. But even with ETFs, you must be prepared for stress-inducing price swings. (SMI uses a gold ETF in our Dynamic Asset Allocation strategy, recommending it when the momentum numbers indicate it is appropriate to do so.)
These investments are promoted as having the advantage that “your loss is limited to the amount of your investment.” In other words, all you can lose is every dime you invest (which does make options safer than futures contracts)! Options trading — available via all major online brokers — gives you the right to buy (a “call” option) or sell (a “put” option) a stock, an index, or an ETF later. The terms include an agreed-upon price (the “striking price”) as well as an expiration date.
Because of the complicated interaction of current price, striking price, and the time remaining, options trading is not for the inexperienced. (That said, conservative option strategies, such as writing covered calls, may be reasonable for knowledgeable investors.) Further, options trading is inherently short-term in its outlook, aiming to capitalize on price movements that typically must occur within a few days, weeks, or months. The SMI approach, on the other hand, stresses a long-term mindset.
Renowned investment manager John Neff, who led Vanguard’s Windsor Fund to three decades of remarkable outperformance (from the mid-1960s through the mid-1990s), once likened options trading to a roll of the dice: “I’ve never done much with options,” he said. “The odds aren’t so awfully good.” If a man of John Neff’s savvy and experience found options to be an unattractive investment vehicle, what chance do you think the average investor has?
Resist the allure
Each of these strategies — margin, futures trading, options — can be enticing. The potential for profit is great. But the risks are great too, making these strategies unsuitable for most investors. (For an explanation of why SMI uses leveraged ETFs in its Sector Rotation strategy, see Leveraged Funds: Too Dangerous To Be Useful?) Instead, we recommend the kind of long-term, carefully considered approach suggested by Proverbs 21:5: “Steady plodding brings prosperity; hasty speculation brings poverty” (TLB).