The Amateur Financier

If you are a mutual fund investor, you’ve probably heard talk of the Efficient Markets Hypothesis (EMH, not to be confused with EMT or Emergency Medical Technician) being bandied about at one point or another.  In a nutshell, EMH maintains that the stock market and similar markets are efficient.  That is to say, the price of a stock at any given time will express ALL the information available about the stock at the time, and will usually match the fair value of the company.

Obviously, not every stock will exactly match the fair value of the underlying company at every moment; if they did, there would be little change in stock prices on a daily basis, rather than the swings that we see.  EMH holds that these variations are random and unpredictable, and will revert to fair value as a result of investors attempting to exploit the deviations from fair value.  In a liquid, large market with low costs and people looking to gain advantage from these (temporary) variances, the stock price will soon revert to fair value, at least until the next inefficiency arises.  While it’s possible for some investors to benefit from these inefficiencies, doing so depends on luck and not skill, according to EMH.

As with any such hypothesis, of course, there are challenges to EMH.  The most obvious examples are investors such as Warren Buffett who proved able to beat the market repeatedly.  There are also runs on the market, both on the upside (such as the tech boom) and the downside (as during 2008) where investors end up distorting the market in ways that pull prices away from their fair values in a concerted way.  That the stock market is efficient is far from a settled fact.

Efficient Markets and the Individual Investor

All this might seem like just an academic argument, but it has some very real consequences for your portfolio.  If the EMH theory is correct, your best (and in fact, only sensible) investment is in index funds; barring some lucky (and unpredictable) breaks, neither you nor a mutual fund manager can hope to beat the market, and the best you can do is match the market gains while spending as little money as possible.  If EMH does NOT hold, then beating the market via skill could be possible, and finding good stock investments or a solid mutual fund manager looks more reasonable.

So, which is it; do EMH principles apply or not?  I hold that the answer depends on what segment of the stock market we are considering.  Remember, there are several points that need to be true for markets to be efficient:

-Liquid: It should be possible for shares to be bought and solid easily, enabling the price to easily move back to the fair value for the stock.
-Large: A large market both increases liquidity and helps to ensure that information is widely disseminated, enabling changes from fair value to be easily discerned.
-Low Costs: Low costs increase the liquidity of the market, as well as decreasing the shift in value needed for the investment to be profitable.
-People Looking to Profit from Variances: Without people buying undervalued stocks and selling (or shorting) overvalued ones, the stock prices will stagnate, preventing the stocks from returning to fair value.

The closer a particular segment of the stock market is to meeting these criteria, the more efficient it will be.  For large cap stocks, the market is pretty dang efficient; the market for the AT&Ts and Wal-Marts of the world is large, liquid, and filled with people who will pounce on undervalued or overvalued stocks, pushing them towards their fair value.  On the other end of the spectrum, penny stocks tend to be illiquid, have a small market, and typically have added fees that increase the investment costs; all of which point to a really inefficient market that could potentially be exploited by a savvy investor.  (Although, I’d tend not to recommend penny stocks, as the lack of regulation and easy manipulation by unscrupulous charlatans makes the penny stock market highly risky.)  Most other markets fall somewhere in between; small-cap stocks are going to be less efficient than large-caps, but more efficient (and I would add, safer) than penny stocks.

What does this mean for your portfolio?  If you seek market inefficiencies, look for shares that are rather illiquid (think small cap); it’ll be longer before the market as a whole attempts to change the incorrect valuation, allowing the them to get further from the fair value (and potentially increasing your profit, with a well-chosen stock).  When investing in larger-cap stocks, don’t expect market adjusted to drastically and permanently shift your investment value, all public news will be priced into the stock already.

If you’re more of a mutual fund investor, you’ll likely have an easier time finding mutual funds that beat their respect indexes if you look at smaller cap funds.  A fund manager limited to picking from the S&P 500 for the companies in which the fund invests will have to deal with a liquid market keeping the valuations from getting too far out of touch with the fair market value. Larger cap investments should be considered more for the expected growth and possibly dividends.

The Efficient Markets Hypothesis provides some insight into the method behind creating index funds in the first place.  Whether you believe it’s a fact of investing life, think it’s a load of crock, or somewhere in between will impact just how much of your money you want to put into actively managed investments.  Regardless, the more you learn, the better an investor you’ll become, so enjoy the new knowledge!

(Image Taken from The Daily Gazette at Swarthmore)

Yesterday, we talked about the use of leverage when investing, and how it can amplify your returns, whether positive or negative.  In addition, we saw how the interest charged by your brokerage on the borrowed money will lower the returns you make from the borrowed money, regardless of how the investment fares.  If I haven’t scared you away from using borrowed money (buying on margin) yet, here’s another concern: the possibility of a margin call.

In brief, when you borrow money in order to buy securities such as stocks, you need to ensure that you own enough of the underlying security to meet the requirements of both the Federal Reserve Board (FRB) and the exchange on which you purchase the security.  The FRB sets an opening margin requirement of 50% equity in Regulation T, meaning that would every dollar you pay towards purchasing a security, you can only borrow another dollar.  So, if you have $10,000 you want to invest and qualify for a margin account, you can borrow $10,000 from the brokerage to buy the security.

However, once you own the securities, the prices can go up and down, as with any investment.  If the price goes up, the percentage of the securities that you own will increase; however, if the prices fall, you will end up owning less than fifty percent of the underlying security (because the amount that you owe to the brokerage will remain the same, meaning only your share amount will rise or fall).  Both the New York Stock Exchange and National Association of Securities Dealers set minimum margin requirements of 25%, meaning for every dollar in security equity that you own, you can own up to three dollars of the investment held with borrowed money.  (Individual brokers can set stricter requirements, however, so you have to check to ensure you know the rules governing your investments.)

If the value of your securities falls so that your percentage of equity does meet these requirements, you will receive a margin call from the brokerage.  At that point, you will need to either invest more money to bring your equity share up to the minimum requirements, or sell the security (at a loss).  If our example investment suffered a loss of 40%, dropping to a total value of only $12,000, you would hold 17% equity ($2,000 equity divided by a $12,000 total investment) and would be receiving a margin call.  If you couldn’t invest enough new money to bring your stake up to 25% (or your brokerage’s required percentage), you would have to sell the security, pay back the $10,000 and the interest owed, and have less $2000 left of your original $10,000 stake.  Some brokerages may even sell your securities automatically, something else you know about your brokerage before you consider using margin.

Besides showing another example of how using margin can amplify your losses, margin calls can also lead you to sell securities that can rise later.  If our example stock recovers from its decline and goes on to increase in value, not only will the margin call have caused you to sell your shares for a loss, but you will miss out on the upside.  Using borrowed money means that you will need to play by the rules set out by the brokerage, even if they cause you to lose money.

All of this makes using margin rather risky, more so than regular stock investing.  What can you do to avoid the threat of getting a margin call?  Here’s three possibilities:

1) Don’t Use Margin Investing – The easiest way to avoid a margin call is simply to avoid using borrowed money at all.  You will be giving up the upside of using leverage, and will have less money to buy your desired securities, but you won’t have to worry about the whims of your brokerage.

2) Use Less Than the Maximum Margin – You can try to find a middle ground between absolutely no borrowed money and using all the leverage available to you.  If you don’t max out the amount of marginal funds you use, you won’t be as vulnerable to falling stock prices.  In our example, if you only borrow $5,000 in addition to your $10,000 stake (giving you 67% equity) and the stock price declines by 40%, the total value of the investment will be $9,000 ($4,000 as your equity and $5,000 in borrowed funds).  That’s about 44% equity in the fallen investment, more than enough to meet the requirements of the exchanges (although, maybe not your brokerage, if they have a high margin requirement).  Having less borrowed money exposes you to less market risk of falling investments.

3) Keep some money set aside in case of margin calls – If you do decide to use the maximum amount of margin possible and your brokerage will allow you to put more money into your investments during a margin call (rather than automatically selling them), you can keep a portion of your money aside in a safe account dedicated for covering margin calls.  This allows you to take advantage of the benefits of using leverage through a margin account, but with added insurance in case your stocks decline.  (Although, if I had enough money to cover my margin investments, I would just skip using margin investing, invest the money outright and not worry about the rules and complications that come with using borrowed money.)

Any of these methods would allow you to protect yourself from the risks of using margin investing; which one you choose will depend on your own tolerance for risk and investing philosophy.

Chances are, if you have done any financial reading, you’ve heard the term ‘leverage’ being tossed around.  In truth, leverage is just a fancy word for using borrowed money to purchase investments.  The advantage of using leverage is that you can potentially amplify your profits, increasing the return you can get by using your own money alone.  The downside is that you could potentially lose much more more money if your investments turn against you, possibly more than you initially put into the investments.

Let’s consider an example to see how this works.  You’re considering a particular investment, and trying to decide whether to use leverage or not when you make the initial investment.  For this particular hypothetical investment, the maximum amount of leverage you can use is 10 times your investment (that is, for every dollar you invest, you can borrow an additional nine dollars for a total investment of ten dollars).  This is more leverage than you can employ with stocks (which is limited to 2x leverage, where half of the money you put up has to be your own), but much less than with FOREX, options, and many other forms of speculation.  The interest charged on the borrowed money for our example is going to be 6%, just to have a nice round number, and we’re going to hold the investment for a full year, again, to make the math easier.  (In reality, leverage as a technique to enhance your investment returns is usually limited to day traders or others with shorter time frames, but I’m just trying to show a simple example of leverage in action.)

First, let’s look at a good example, one where the investment rises by ten percent, a reasonable amount of profit to expect after one year:

The upside of leverage: enhancing your profits

(Click to view a full-sized image)  Here, we can see the advantages of leverage in full effect.  If you simply invest $100 without any leverage, you’d generate a handy $10 profit from your investment (notwithstanding any transaction fees for buying and selling the investment).  With leverage, though, you’d have invested $1000, ten times as much, and after you paid back the borrowed $900 and the $54 in accrued interest, you’d net a cool $46 in profit (or 46% return on your investment) .  (Note: thanks to the interest charged on the borrowed money, you don’t earn ten times the profit as you would earn without leverage; the interest rate is an important consideration when considering leverage.)

So far, so good, right?  Leverage leads to greater profits; why not use it?  Well, let’s look at the downside of leverage, what happens when the investment goes against you:

The downside of leverage: increasing losses

This time, without using leverage, you would lose $10 when the market value of your investment decreases, a ten percent loss to correspond to a ten percent decrease in the asset value.  With leverage, however, the ten percent loss causes you lose your entire $100 stake in the invest.  But that’s not all: remember, you need to return not only the $900 you initially borrowed, but also one year’s interest for our particular example.  All told, you need to pay back $954; when you add the interest you pay on your leverage to your own losses, you end up losing $154 on your $100 initial investment, for a total investment return of -154%.  The only way to really ensure that you make money off of leverage is to be the broker or bank lending out the money for leverage; in both of our situations, the lender made 6% profit on the borrowed $900.

Does this mean you should not use leverage?  Maybe; certainly, you should be very, very careful when using leverage.  Use it sparingly, if at all; as mentioned, with stocks, you can only borrow an amount equal to your own invested money, and you should probably borrow less than that full amount, anyway.  Make sure to monitor your investments closely; if your stake in the investment gets too low, your lender may require that you invest more money or sell some of your holdings (in what’s known as a margin call, which we’ll discuss more tomorrow).  Above all, ensure that you don’t take more risk than you need or want to take to meet your goals.

This is just a basic overview of leverage and using borrowed money to make your investments; tomorrow, we’ll cover more on this topic.