On any given morning right now, it’s no surprise to find stock prices opening lower than where they closed the previous day. We are living in an unprecedented period of market volatility where predicting “what’s next” is impossible.
In these uncertain and emotionally trying times, how should individual investors react? When is it time to sell portions of a portfolio? When will we reach the bottom of the market? When is it appropriate to start buying more stocks, and which ones?
In order to make sense of the current market volatility, it’s helpful to understand an important contributing force driving the mass sell-off of stocks: margin calls.
Following is an explanation of what investors need to know about the mechanics of margin calls, and the emotional response they can trigger for individual investors. By understanding the “why” of what’s happening and “how” to react, my goal is to provide a way for investors to reclaim a sense of control in this chaotic environment.
How Margin Calls Work
When things are going well in the stock market (as they have been in the 11-year bull market that just ended), investors become confident. A select group of investors becomes so confident that they borrow money to buy more stock using their existing stock holdings as collateral.
Here’s how it works:
- An investor holds $100,000 in ABC stock and the bank will let the investor borrow 50% of the value of ABC stock at a 4% interest rate.
- The investor takes out a $50,000 loan against their ABC stock and invests the borrowed money in XYZ stock. The investor now holds a “leveraged” position in XYZ stock.
- The desired scenario for the investor is for ABC stock to hold its value while XYZ stock increases in value at a higher rate than the 4% interest.
As part of the inherent risk of investing in stocks, there are countless scenarios in which stock XYZ might not appreciate at the desired rate – a declining stock market being among the worst-case scenarios. The rapid spread of COVID-19 and resulting economic fallout provides a powerful lesson on the potential consequences of holding a leveraged position in a market downturn.
Going back to our example, let’s now assume that ABC is an airline stock in the current environment.
- Over the course of two weeks, the value of the investor’s ABC holding has dropped from $100,000 to $60,000.
- The bank calls the investor to remind him that his loan is only approved for 50% of the value of ABC stock, which is now $30,000.
- This “margin call” from the bank means that the investor must reduce his loan amount from $50,000 to $30,000 – and that he immediately owes the bank $20,000.
- Fortunately for this investor, XYZ is a grocery chain where business has picked up recently as people stock up on supplies.
- The financial fundamental value of XYZ stock is sound, but the investor is forced to sell $20,000 worth of XYZ stock and give the cash to the bank to cover his margin call.
If enough investors are in the same leveraged situation, it can cause XYZ stock to decline even though the financial fundamentals of that stock remain sound. This ripple effect demonstrates how stocks that should hold their value can still be impacted during a financial crisis.
How Margin Calls Can Drive Emotional Reactions
Now let’s consider the other shareholders of XYZ grocery chain stock. They see the price of their stock plummet. Reacting emotionally to this sudden price drop is pure instinct: it’s called fear. The common, fear-driven reaction is to sell now at any price before the price drops any further. But making such a knee jerk reaction can do more harm than good to an investor in the long run.
When living in an emotionally-wrought time as we are now, it can be difficult to overcome fear by applying logic – but using current data and historical evidence is a more appropriate way to guide action in a crisis than allowing fear to prevail. It’s important to lean on your advisor to employ logic rather than fear to make potential adjustments to your portfolio.
Playing cards with my then four-year-old son Charlie offers a great illustration of this concept. Stuck indoors one rainy afternoon, I made up a card game to entertain him. We had a deck of cards that, as everyone knows, has 50% black cards and 50% red cards.
Before we started, I told Charlie that I would deal five cards face up. The black cards would be counted as positives and the red cards would be counted as negatives. Whoever had the higher score at the end of the deck would win. Charlie got to choose who got the five cards before each hand.
Not surprisingly for a four-year-old, Charlie opted to take the first hand. His first five cards all turned out to be red, resulting in a stinging score of -45. I asked him if wanted the next hand, to which he emphatically replied “no!”
Charlie’s decision was innate and driven by fear of receiving another bad hand. At four years old, he couldn’t rationalize that the deck now had more black cards than red cards and that the next hand was therefore likely to be better.
Throughout the game, if he got all black cards in a hand, he would always take the next hand. After playing a few games, I explained to him why he had been losing. Once he understood that the deck contained 50% black cards and 50% red cards, he made better decisions.
No one knows the future prices of the stock market. Historically, it has provided investors with more black cards than reds cards. Unfortunately, drawing red cards is part of investing.
How CornerCap Can Help
Your investments are obviously much more serious than a card game. But in these trying times, many investors tend to react the same way Charlie did; it’s simply human nature. However, if we can acknowledge and tame our own fear-driven tendencies in times like this it can help us to make more sound decisions.
When it comes to your investment portfolio, you are not alone during this frustrating time. Your CornerCap team is here to help you make decisions for you and your family based on the specific make-up of your portfolio. We are here to address your portfolio needs, as well as to guide you away from reacting emotionally in the current environment.