Before I begin this week’s column, let me thank each reader who sent me an email or participated in last week’s survey. I had asked for your help in understanding your needs as a reader of this column. I’ll keep the survey open for another week to enable you to participate if you did not have a chance to do so last week. Link to it here: https://www.juliejason.com/survey. I’ll share the results with you next week. I look forward to your feedback.
When the topic of financial literacy comes up, it’s usually about the average person who is not an avid trader. It’s always interesting to learn about the know-how of more expert investors, such as those who trade on margin.
Instead of paying in full, margin purchasers enter into an agreement with the brokerage firm to borrow money to pay (partially) for securities purchases.
The purpose of margin is to give the customer more buying power. Like everything else that uses leverage, the potential for loss is magnified.
So, someone who engages in margin trading must be a more informed investor, right? In a recent study, margin account investors were given a chance to test their knowledge. Try your hand at this question, one of 10 intended to measure an investor’s understanding of margin trading:
“You invest $500 to buy $1,000 worth of stock on margin. The value of the stock drops by 50 percent. You sell it. Approximately how much of your original $500 investment are you left with in the end?”
Which is the right answer? (1) $500, (2) $250, (3) $0, (4) Don’t know, and (5) Prefer not to say.
Now, here is what’s interesting: Only 15 percent of margin traders answered this question correctly (the correct answer is (3)). People who did not have margin accounts (non-margin traders) did better (31 percent answered correctly).
Looking more closely at the responses, only a few answered (4) or (5). Eighty-one percent of margin traders incorrectly responded either (1) or (2), compared with 49 percent of non-margin traders.
Here’s more: The study also found that margin traders exhibited “lower levels of overall investor literacy.”
Margin traders scored 41 percent accuracy on the 10-question financial literacy quiz. How did the non-margin traders do? A little better: 50 percent.
Margin traders may be a bit too confident in their knowledge, the authors of the study conclude: “Overconfidence in investment knowledge appears to be a key element in explaining why lower-literacy traders gravitate toward margin.”
To read about the 2018 study, “The Financial Illiteracy and Overconfidence of Margin Traders,” go to https://tinyurl.com/yby637tz.
Before I leave the subject, let me give you an example of how margin works, quoting from a report from FINRA, the Financial Industry Regulatory Authority:
“[I]f a customer buys $100,000 of securities on Day 1 ... [the customer] deposit[s] margin of 50 percent or $50,000 in payment for the securities ... Assume that on Day 2 the market value of the securities falls to $60,000. Under this scenario, the customer’s margin loan from the firm would remain at $50,000, and the customer’s account equity would fall to $10,000 ($60,000 market value less $50,000 loan amount).”
Due to “minimum maintenance margin requirements,” the customer will need to add $5,000 to his account. The required equity is $15,000 ($60,000 market value times 25 percent). “Since the required equity is $15,000, the customer would receive a maintenance margin call for $5,000 ($15,000 less existing equity of $10,000). Because of the way the margin rules operate, if the firm liquidated securities in the account to meet the maintenance margin call, it would need to liquidate $20,000 of securities.”
I think it’s pretty clear that someone who wants to trade on margin needs to be informed. A good place to start is FINRA’s report, “Purchasing on Margin, Risks Involved with Trading in a Margin Account,” at https://tinyurl.com/y7glwlph.
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Julie Jason, JD, LLM, a personal money manager (Jackson, Grant of Stamford, Conn.) and author, welcomes your questions/comments (firstname.lastname@example.org). Her awards include the 2018 Clarion Award, symbolizing excellence in clear, concise communications. Her latest book, a curated collection of Julie’s columns, is “Retire Securely: Insights on Money Management From an Award-Winning Financial Columnist.” To hear Julie speak, visit www.juliejason.com/events.