The liquidity curse (beware of the risks of margin debt)

This is another timeless article by Nuclo Independent CIO head of global equities Claudio Brocado. While over six years old, the excerpt in the paragraph below — as just one example — demonstrates its applicability even to today. News that a highly-leveraged institution was forced to liquidate billions of dollars worth of investments (notably stocks) on Friday again highlights the risk of investing using large amounts of margin debt. Sadly, over shorter periods of time, even prudent market participants are negatively impacted. For example, if equities rather conservative investors own are major bets of highly leveraged hedge funds, a long-term oriented portfolio can suffer meaningful mark-to-market short-term losses nonetheless.

“How could trading liquidity ever be a bad thing? In the short run, better stock liquidity can certainly work against a stock price. Particularly in severe market-wide corrections (or if a specific stock is heavily owned by leveraged traders), a liquid stock may suffer disproportionally in the short term as traders take advantage of the relatively high liquidity to raise cash. This is when particularly attractive entry points are often created for long-term investors, but also why I advocate that such investors never use margin debt to increase their exposure to stocks.”

The key is not to ‘panic sell’. If anything, long-term oriented investors should use any such volatility to buy (or add to) positions in stocks they have wanted to own in the long run, but for which they have been awaiting a better entry point.