Don’t Borrow Money to Buy Stocks

Much of the recent market decline has been due to forced sellers like hedge fund and mutual fund managers that have had no choice but to sell stocks they own due to redemption notices from their panicked investors. In many cases, forced selling has also taken the form of margin calls.

Consider the shares of long time Peridot favorite Chesapeake Energy (CHK) which fell 50% in just the last 3 days of last week. The stock movement felt like panic selling and late Friday we learned that the company’s largest shareholder (the co-founder and CEO) was forced to sell most of his 5% stake in the company between Wednesday and Friday. Why? To meet brokerage margin calls that were triggered because he had bought the shares in part with borrowed money.

For the most part, I would never recommend that individual investors borrow money to buy stocks. Every so often there are arbitrage opportunities that can be completely hedged and therefore using margin can pay off if downside risk can be hedged away, but speculating on a stock price’s future movement based on fundamental bullishness (as was the case with CHK) with borrowed money is a recipe for potential disaster.

Aubrey McClendon, Chesapeake’s CEO, has paid the ultimate price by being forced to sell 94% of his stake in his own company in the middle of one of the most panicked weeks the market has ever seen. Don’t make the same mistake he did by speculating with borrowed money. Leverage has crushed the investment banks, but it can get individuals in deep trouble too.

Full Disclosure: Peridot was long shares of CHK at the time of writing, but positions may change at any time