Volatility and margin calls: how you respond to a margin call depends on your planning, confidence and cash

Money Digest, June, 2000 by Talbot Stevens

Stock markets have given investors a wild ride recently. If you borrowed to buy some of your investments, you may have gotten a crash course (pun intended) on margin calls.

Lenders like to get their money back, and often hold what is called collateral to reduce their risk. Collateral can be anything of value that the lender can sell to pay off the outstanding loan.

If your collateral is investments, and their value falls enough, the lender could issue a margin call. Whether you use a loan to buy mutual funds or a margin account with a broker, a margin call is a demand to increase the value of the collateral in the account.

The margin call can be dealt with by transferring additional cash or other investments into the account. If additional collateral is not available, some of the investments will have to be sold to generate cash. Unfortunately, selling when the investments are down locks in your loss and ensures that you experience the negative side of leverage.

Borrowing to invest or leveraging can be one of the most powerful wealth-building strategies that exists, but it is a double-edged sword that magnifies returns, making good returns better and bad returns worse.

One guideline for implementing leverage responsibly is to eliminate the risk of a margin call. It is wise to take steps to avoid a margin call because it almost always hurts the investor.

Borrowing to invest doesn't just leverage or magnify returns, it magnifies emotions as well. Having investments you own drop by, say, 30% is painful enough, but when it happens with borrowed money, the fear is heightened and most end up bailing out and selling at the worst time.

While a margin call is normally viewed as negative, it can actually benefit the investor. If a leveraged investor has sufficient understanding, commitment, and resources, a margin call can be a blessing in disguise. Knowledgeable investors understand that diversified equity investments experience short-term fluctuations that average out to good long-term returns.

If you have the confidence and cash, a margin call can be the trigger to buy more investments when they are down. Instead of the margin call forcing you to sell at the worst possible time, it could cause you to buy more investments at one of the best possible times.

Many margin calls were issued in the fall of 1998 when most markets dropped about 30%. Those that had faith in their long-term plan were actually better off financially than if there had been no margin call. The margin calls forced some to buy more at significantly lower prices, and in this case, the markets rebounded within a matter of months.

How you respond to a margin call ultimately is a measure of whether or not you were using leverage in a responsible manner and fully understood the downside.