Why Is It Risky To Buy Stocks On Margin But Prudent To Buy Them On Mortgage?

Clients who need to improve their prospects for retirement generally have three options: spend less, save more, or retire later. Technically, there is a 4th option — grow faster — but it is typically dismissed due to the risk involved in investing for a higher return. In practice, clients rarely seem to dial up the portfolio risk trying to bridge a financial shortfall in retirement, and taking out a margin loan just to leverage the portfolio to achieve retirement success would most assuredly be deemed imprudent and excessively risky. Yet at the same time, a common recommendation for accumulators trying to bridge the gap is to keep any existing mortgages in place as long as possible, directing available cash flow to the investment portfolio, and giving the client the opportunity to earn the risk arbitrage return between the growth on investments and the cost of mortgage interest. There’s just one problem: from the perspective of the client’s balance sheet, buying stocks on margin and buying stocks on mortgage represent the same risk and the same leverage, even though our advice differs. Are we giving advice that contradicts ourselves?

The inspiration for today’s blog post comes from several conversations I’ve had recently with planners since my blog post a few weeks ago about how planners never tell clients to take out a loan to contribute to a retirement plan, yet willingly tell clients to contribute to 401(k) plans instead of paying down a mortgage, despite the fact that it’s comparable when looking at the entire balance sheet. In the discussions both in the comment section of the blog and offline, I began to realize we as planners have some oddly contrasting advice about debt and what is and is not risky.

For example, imagine 3 clients, who we’ll call A, B, and C. Client A has a $500,000 residence with a $500,000 fixed-rate 30-year mortgage at 5.0%, and a $1,000,000 conservative portfolio with a beta of 0.5. Client B has a $500,000 residence with no mortgage, and a $1,000,000 conservative portfolio with a beta of 0.5 that is collateral for a $500,000 variable-rate margin loan with a 5.0% interest rate. Client C has a $500,000 residence with no mortgage and a $500,000 aggressive all-equity portfolio with a beta of 1.0.

If you asked a typical planner which of these clients was the least risky, virtually all of them would answer client A, with the stable mortgage and the conservative 0.5 beta portfolio. After all, client B has a giant margin loan against his portfolio — clearly risky — and client C is high-risk due to the incredibly volatile portfolio being fully invested in equities with a beta of 1.0, twice that of client A.

The problem is, when you look at the impact of short-term market volatility on the client’s entire balance sheet, client A is not less risk-exposed than client B. In fact, all three clients have the exact same exposure to market volatility! To see why, let’s look first at the current balance sheet for all three clients, as shown below: