Margin Call

Often the greatest impact from events occurs at the margin. My theory is that small incremental changes can cause disproportionate outcomes.   For example, just a few thousand people in a handful of states decided the 2016 Presidential election for a nation of 330 million people.

In economics there is equilibrium when supply equals demand. That said, when either supply or demand shifts – even just a little – there can be a huge change in prices.   When there is a reduction in OPEC oil or a disruption to refinery production after a hurricane in the Gulf, gas prices can escalate rapidly. We can cynically wonder why gas prices never seem to fall back as quickly as they rise, but there is no denying that gas prices are very sensitive to supply and demand forces.

Security prices operate under similar supply and demand dynamics, as markets of buyers and sellers bid against each other based on common information, which drives prices to converge to a consensus price.   With all information accounted for and baked into prices for stocks and bonds, the consensus or market value is not going to change much unless there is new information. Just a little new information can cause a major variation in price. For example, news about the Coronavirus impacted many stocks – some more than others – because of the implications for the broader economy. Of course for events like this, the psychological impression is often greater than the true economic threat.

Buying investments with borrowed money, such as real estate or stocks on margin, the leverage can magnify the potential swings in price.   For instance, if a stock bought on margin heads south even by a fairly small amount, the investor could suffer a margin call and potentially be wiped out.

Marginal analysis can be very helpful for tax planning.   Taxes are paid in layers or “brackets” whereby the tax rate increases based on a person’s income bracket.   The highest marginal tax rate does not mean that all income is taxed at the highest rate, rather, just the income in that particular bracket.   Income is taxed at different rates as income increases from one bracket to the next, which is known as “progressive taxation.”  While it might be interesting to know your average tax, it’s your top bracket – or marginal tax rate - that is more relevant for decision making.   What will be the incremental tax for an additional amount of income? The answer determines your marginal tax rate and this information can be used for a variety of decisions, such as should you save with pre-tax dollars like with a 401(k), or use an after-tax account like a Roth IRA?  

Many people don’t realize that the ordinary tax bracket also determines your tax rate for certain investment income. When you sell an asset for a gain or receive qualified dividends, there is a separate rate structure. If you are in the 22% or higher normal bracket, your tax rate for dividends and capital gains is 15%. That said, if the regular bracket is below 22%, your rate for dividends and capital gains is zero. That’s quite a difference! So keeping your income below the breakpoint between ordinary income brackets might permit you to sell appreciated assets and pay no tax whatsoever.  

Let’s say you are nearing retirement and have a stock with a large unrealized gain that you would like to sell.   While you are working, you might have to sell in the 22% ordinary bracket and therefore pay 15% tax on the gain.   Delaying the sale until the year after retirement when your tax bracket drops, could allow you to avoid all taxes from the sale (depending upon the amount sold). Of course you would have to weigh the tax savings against the risk of continuing to own the stock. Good marginal analysis could use the progressive nature of our tax system to your advantage.  

Let me give a final example of incremental analysis that few people ever think about.   When weighing a decision of how to manage your portfolio, what will be the true marginal impact of the decision? I find that most people who have accumulated significant assets will always have enough money for their personal needs whether or not they invest wisely. They will ultimately leave an estate to their heirs as a matter of course – whether it’s their intention or not.   The specific rate of return will not change that outcome – only the amount left behind will change based on how well they invested. In other words, as long as they have a good plan their lifestyle will not be affected one bit by the investment results. Because they’re not spending all the earnings anyway, their income will be sufficient under either a good plan or a great plan.   The incremental impact of their investment decision will not be felt by them during their lifetime - but it will be felt by their heirs.  

I’m not saying that you should invest for your heirs. Certainly, you should focus on your own needs first and foremost. But if personal needs are covered, shouldn’t we at least consider that an estate will probably be left and that management decisions could have a greater bearing on the amount left for beneficiaries?  

For example, a $1 million portfolio invested for 30 years at 6% might grow to almost $5.75 million, whereas if invested at 4% it would reach about $3.25 million. There aren’t too many recipients that wouldn’t be happy with such a windfall, but the difference is still $2.5 million or 43.5% less wealth!  

You might be surprised by how many investors surrender 2% of their portfolio return because they pay unnecessary investment advisory fees. Many people pay an advisor 1% of their assets under management (AUM) and another 1% in mutual fund operating expenses for a total of 2%. There are other fee structures used by advisors, but I find that active money management costs about 2% per year. In such a case, a 6% return could easily shrink to 4%, and underperform a comparable portfolio of index funds with negligible expenses by about 2% per year.

Before embarking on an investment program, you might want to use marginal analysis and ask yourself “What will be the true incremental impact of your decision?”      If there are people you care about, family or otherwise, you should be as efficient as possible with your investments. Poor investment could cost many thousands of dollars, and potentially millions. At the margin, you’re probably not the only party with a stake in your investment results. The marginal cost of a bad decision could be to give your hard-earned money to strangers instead of leaving it to your children, church, or favorite charities.