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EVERY week before I choose a topic to write, I weigh between the topics I enjoy writing versus an urgent need to address a pertinent issue in the realm of economics, finance or policies. After much thought, I decided to focus on this issue as it would be a great disservice if I do not use this column to raise awareness on the pitfalls of margin financing for retail investors.
What prompted me to do so is because a renowned investor blogger recently strongly encouraged retail investors to take up margin financing to invest in a steel trading small cap company called AYS Ventures Bhd. He cited his optimism in the company’s prospects as well as his past success and experience as a founder of several listed company.
In my humble view, such promotional and misleading writing is terribly dangerous to retail investors, especially those who are new and inexperienced.
Regardless of his intent, which I do not intend to dwell upon, I think it is important to first understand the concept of margin financing and how it functions. Only by understanding the nature of margin financing, both its strength and weaknesses, one can make a truly informed decision.
Margin financing is a facility provided by investment banks or brokerage houses where they provide credit lines based on the shares pledged to them as collateral.
As the share prices rise, the value pledged to the bank increases, this in turn increases the facility amount. With additional credit facilities, investors would have more funds to make investments in the stock market. However, margin financing does not come free.
For the facility granted, the investment banks or brokerage house charge a fixed interest per annum, which is usually within the range of commercial loan rates.
It becomes a healthy recurring revenue stream for the banks and brokerage houses which compensate for the fall in income from transaction fees due to competition.
This will also help sustain operations of the dealers and brokers. You can compare the margin financing rates of different investments banks in which are subject to respective banks’ internal approvals (see table).
Now, all is well and good when the market is on an uptrend and the stock market is roaring. The problem comes when the tide turns.
Before cryptocurrencies came about, the forex markets were often considered one of the most volatile investment asset classes.
The equities market is a close second. For that reason, the stock market is not for everyone as the frequent fluctuations in share price movements makes it especially hard for emotionally driven investors.
When the stock market fluctuates, it means the share price would not move up in a straight line but rather go through wild swings. Those who use margin financing would then be subjected to two very dangerous situations. One, is the interest rate to be repaid and two, is the potential risk of a margin call.