Legendary investor Warren Buffett has made it clear in his latest letter to Berkshire Hathaway Inc. (BRK.A) shareholders that he's no fan of margin debt, or loans used to buy stocks. And the billionaire's comments couldn't have come a minute too soon. Investors have accumulated a record $642.8 billion of margin debt, the highest level since the Dotcom Bubble, which worsened the recent correction and threatens to intensify future sell-offs, The Wall Street Journal reports. When it comes to margin debt, Buffett told CNBC , "Even if your borrowings are small and your positions aren't immediately threatened by the plunging market, your mind may well become rattled by scary headlines and breathless commentary. And an unsettled mind will not make good decisions."
The big risk is that stocks are pledged as collateral against these loans, and when the value of that collateral falls in a market plunge, borrowers face what are known as margin calls, forcing them to sell shares, the Journal notes. This, in turn, sends prices yet lower, setting off additional rounds of margin calls followed by yet more selling.
That's what happened during the latest market correction that has rattled so many investors. In fact, the Investopedia Anxiety Index (IAI) indicates that millions of readers worldwide remain extremely concerned about the securities markets, with worries about margin debt undoubtedly being a factor.
Dotcom Bubble Revisited
Based on data starting in 1980, net margin debt in 2017 reached a record 1.31% of the total value of shares traded on the New York Stock Exchange (NYSE), per analysis by Goldman Sachs Group Inc. (GS) cited by the Journal. The previous high, per both sources, was 1.27% during the Dotcom Bubble that began deflating in the year 2000. Just as buying stock on margin had a role in fueling that market boom, cascading margin calls had a role in intensifying the subsequent Dotcom Crash.
'Strongest Argument Against Borrowing'
In his letter to shareholders, Buffett cites own experience with Berkshire's shares as "the strongest argument I can muster against ever using borrowed money to own stocks," as quoted by CNBC. When Buffett took over Berkshire in 1964, the stock was valued at about $19.00. Its opening price was $311,240.00 on February 26, meaning that each dollar invested in 1964 now would be worth a mind-boggling $16,381.05. (For more, see also: If You Had Invested Right After Berkskire Hathaway's IPO.)
But Buffett points out this was not a smooth upward ride and that investors who bought his company's shares with margin debt got burned. In the intervening years, Buffett said Berkshire's stock has endured four periods in which it endured big declines: down 59% in 1973-1975, down 37% in 1987, down 49% in 1998-2000, and down 51% in 2008-2009. "There is simply no telling how far stocks can fall in a short period," he writes, as quoted by CNBC. Investors who had bought Berkshire on margin would have had to liquidate much, if not all, of their holdings to meet margin calls during those downdrafts, thus missing out on spectacular future gains.
"For the last 53 years, the company [Berkshire] has built value by reinvesting its earnings and letting compound interest work its magic," Buffett also writes, again per CNBC. Ever the realist, he also warned that big drops in its stock price similar to those mentioned above are likely over the next 53 years. "The light at any time can go from green to red without pausing at yellow," he observed.