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News Release: 00-06
GRAY DAVIS, Governor
Date: 04/19/00
WILLIAM KENEFICK, Acting Commissioner
Department of Corporations Issues Warning about Margin Trading
Trading with other people’s money "magnifies risk"
Sacramento, April 19, 2000 — The Department of Corporations joined other state securities regulators today in cautioning investors about potential pitfalls of buying stock on margin, a growing trend that magnifies risk in a volatile investment marketplace. The Department warned that the long term bull market has induced many small investors to try to "leverage" their profits by borrowing money from their broker to purchase more stock than they could with a cash account.
Margin debt has accelerated rapidly over the past year, reflecting the overall bullish sentiment on Wall Street and the influx of new investors into the stock market. Many of these investors are engaging in day trading, bidding up prices of initial public offerings and participating in other speculative trading strategies. Such speculative practices have contributed to driving the Dow Jones Industrial Average from 2500 to over 11,000 since 1992, and causing the NADSAQ composite index, home to many high flying high tech stocks, to top 5000.
Margin rules are part of the national monetary policy and allow investors to borrow up to 50% of the value of their stock portfolios to purchase additional stocks. If their stocks decline in value they could receive a "margin call" from their brokerage firm, requiring them to put more money into their account by a certain date. If they can’t comply, their stocks could be sold at whatever the market price is at that time, potentially subjecting the investors to heavy losses in a down market.
The Department advises investors to treat margin like any other consumer loan and to use it responsibly and prudently. Margin loans only make economic sense if investors are convinced that their stock portfolio, the asset securing the loan, is likely to go up enough to cover the finance charges and commissions. Because of their multiplier effect, margin loans can exacerbate losses and wipe out years of effort that went into building a stock portfolio.
As recent market fluctuations have shown, a long term bull market can quickly be replaced by a highly volatile market that is bullish one day and bearish the next, so margin should be used conservatively and consideration of the risks of loss should be part of the financial planning involved.
Investors are urged to carefully read their brokerage firm’s margin loan policies and to contact their stockbroker if they have questions. In response to complaints that many investors have been engaging in particularly risky strategies such as using borrowed money to buy highly speculative securities, like shares in Internet startups, some online brokerage firms have restricted margin lending for some speculative stocks. Many securities professionals are suggesting that margin requirements should be tightened to protect investors from becoming overextended.
The Department cautions investors that recent volatility in the stock market shouldn’t necessarily cause them to question their commitment to a long-term diversified financial portfolio, noting that market gyrations are more troublesome for "traders" than for "investors." "Traders" are looking for short-term profits by betting on the direction the price of a stock will go. They rely less on the fundamentals of financial analysis than on formulas and "momentum." Traders sweat the minute-to-minute moves of stocks and trade frequently. Investors take the long-term view and regularly put money into savings, mutual funds, 401(k) plans or a diversified portfolio of individual stocks or mutual funds.
Fortunately, most Americans are investors, not traders, and they’re unlikely to question their long-term commitment to saving and investing because of some wild
The Department of Corporations is California's Investment and Financing Authority, reporting to the Business, Transportation and Housing Agency and the Governor. The Department is responsible for the regulation, enforcement and licensing of securities, franchises, off-exchange commodities, investment and financial services, independent escrows, consumer and commercial finance lending and residential mortgage lending. For further information or to obtain a complaint form, see the Department's Web site at www.corp.ca.gov.
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