Don’t Buy Stocks on Margin, Unless you are an Expert

Most academic economists are irrelevant, so we can ignore them.  The few that are relevant are worth noting.  They can write such that ordinary people can understand — think of Milton Friedman with his “Free to Choose.”  Such economists are viewed skeptically by the “profession” because they interact with the unwashed.

So it is with Ayres and Nalebuff.  I have rarely been impressed with what they write.  Like Freakonomics, they write about stuff that is sensational, and challenge the conventional wisdom.  Yo, the conventional wisdom is right most but not all of the time.  Anyone that focuses on where the conventional wisdom is wrong will commit a lot of errors in an effort to be novel.

Now, Abnormal Returns and Sentiment’s Edge have made their polite comments, but now it is time for my less polite comments. I have five main critiques of their paper, which stems from the lack of practical experience in the markets for these two professors.

1) History is an accident.  It is fortunate that they are analyzing the US, rather than nations whose markets got wiped out during a war.  It is not impossible that the US could face a similar crisis in its future.  Try the same analyses with Argentina or Peru.  Will it work?

2) Even in the US stocks don’t outperform bonds by that much.  My estimate of the equity premium is around 1%.  Yes, the economics profession says the equity premium is higher, but they use a wrong metric; they should use dollar-weighted returns, not time-weighted returns.  The estimate of 4% equity returns over margin rates, which are higher than bond yields, is hooey.

3) Average people aren’t capable of managing portfolios that are 100% equities, much less levered equities.  It is well known that people invested in equity funds tend to buy and sell at the wrong times.  It would be far worse with leveraged portfolios.

4) Leveraged ETFs tend to underperform over time, have you noticed?  This is a mathematical necessity.  Through options and swaps, which have larger bid-ask spreads, maintaining the leverage is at low cost is tough.  If the advantage over margin rates were true, there would be real advantages to leverage.

5) What if everyone did it?  The paper is a typical, “If you had done this in the past, you would have done a lot better.”  Duh, and I can do better versions of that than the authors.  Going back to point one, history is an accident, and cannot be relied on.  Point two, their math is wrong.  Point three, average people can’t implement it.  Point four, those who try to do this don’t do as well as you might expect.

The last point is that everyone can’t do this.  Can you imagine what would happen if everyone aged 25-41 suddenly invested into equity exposure equal to twice their assets?  Stock prices would shoot up, and would offer little future returns to holders.  Stocks aren’t magic, and over the very long haul, they tend to return what the GDP does plus a few percent.

Think of Alan Greenspan encouraging people to finance using ARMs at the worst time possible.  The authors here encourage young people to speculate on equities with leverage at a time when the market is somewhat overvalued.  If this were a good idea, you would have seen many people doing it already, and it is not a common practice.  Don’t listen to academics that have little practical experience for investment advice.

One final note: when I wrote at RealMoney, I took a contrarian view that for average investors, no one should be fully invested.  Even the great Ben Graham never exceeded 75% invested.  My view is that average people must limit their risks or they will not be able to sustain their investment plans.  A 50/50 or 60/40 balanced fund approach is best for the average person — they will never get scared enough to abandon it.

Leverage is for experts only, and I have never used leverage.  Only use leverage if you are more of an expert than me.  (I write this not out of pride, but out of my experience where so many have gotten burned by taking too much risk.)


  • Tom A. says:

    Re: History is an accident

    I’m not sure just how much professionals (experts?) understand just how much of an accident history was. Think about Monte Carlo simulations — you can generate as many draws about the future as you’d like. But history was the only one of those MC simulations that actually occurred. Yet most professional quant investors run their simulations over the same vector of history without regard for the possibility that it all wasn’t inevitable. Investors and consultants have been trained to expect historical simulations, if not accept them.

    2. In addition to Graham’s recommendation, there’s another authority on investing (gambling) with leverage: Ed Thorpe. Who’s more of an expert on applying leverage while investing than he is? Yet according to “Fortune’s Formula,” whatever allocation level appeared optimal by Thorpe’s analysis, he would automatically halve it to allow for his analysis not holding true in the future.

  • Ed says:

    Leveraged ETFs would underperform naive expectations over the long term even in the absence of any market frictions – its a byproduct of market volatility and the fact that they’re forced to rebalance daily.

  • Josh Brown says:

    I could not have said it better myself. These two geniuses should spend a few months holding stocks on margin themselves (with their own capital as the equity collateral) before telling kids right out of college to do the same.

    The premise of the paper is embarrassing and dangerous.

    Thx for posting this.


  • Josh Stern says:

    I think your point about dollar weighted vs. time weighted returns is important and merits a full column where you could break out some cases – e.g. a portfolio that is only to be used to fund retirement and where the annual contribution is fixed vs. one where there is a potential choice between investing and paying off or not taking on debt.

    Regarding your advice for allocation of the average investor, I worry that some of these average investors would also become tempted to get 100% long equities near market tops after starting out with your suggested balance. My personal advice would be rather to start out with some standard version of equities vs. bonds vs. cash as a function of distance to retirement and stability of current income and then tweak it in some objective way that moves it somewhat toward the direction of buying low and selling high, provided the individual can fully grasp and monitor the chosen method and have the discipline to stick to it.

  • Ross says:

    I’m a firm believer in using appropriate amounts of leverage in appropriate situations. I bought my first house with 90% leverage, but I lived in the basement and the upstairs rent covered most of the mortgage. I bought a bunch of distressed real estate in another city with 100% leverage, but the cap rates were so high that even with vacancies, repairs, etc., the mortgages were covered. Last year I bought stocks with 200% leverage, but they had fallen so far and the government was pumping so much money into the economy, they had to go up sooner or later.

    In each case I made a lot of money that I wouldn’t have without leverage, and I’m no expert. (Currently, I’m almost completely deleveraged while looking for new opportunities.)

    Granted, most people couldn’t invest this way. When I explain what I’m doing to other people, they always shudder and say, “I couldn’t sleep at night!”

    Leverage is a powerful tool and like all powerful tools, it can bite you if you’re careless. But used wisely, it will give you returns that are otherwise impossible.

  • David – You have done some careful work on valuation. The last time you did an update, stocks were under-valued and the margin was fairly significant.

    I am curious about your statement in this piece that the market is “somewhat overvalued.” How does this relate to your work on comparing with corporate bonds?



  • Mike C says:


    Just wanted to say I’m hoping you will address the question Jeff raises when you have a chance. I know I am interested. IMO, one of the most difficult questions I ask myself every single day for my account and the accounts I manage is what percentage of the desired equity allocation should I have invested or to what degree should I be hedged (index puts or SDS) at this point in this move and at this valuation level.

    Jeff and I have gone back and forth on the Shiller P/E and I am trying to find a way to integrate what it says with other metrics that perhaps are more “generous” on valuation. Fact of the matter is alot of super-conservative valuation metrics missed the entire 2004-2007 run despite the fact that ultimately the 2007-09 bear gave it all back.

    My most probable scenario is we are in a replay of the 2003-2007 cyclical bull market and right now we are only in 2004 except that I expect this cycle to be shorter and not reach 1500ish before the next bear hits. Sentiment and technical measures seem generally supportive of a continued move higher.

  • Mike C, I will try to answer the question in the next month or so. I am playing around with a few models. My main concern is the sustainability of profit margins, which my “Fed Model” assumes are sustainable.