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This Hedge Fund Disaster Has a Lesson for Every Stock Market Investor | The Motley Fool

Monday was another turbulent session on Wall Street, as the stock market saw large-cap stocks recover from sharp declines to begin the day. After having been down as much as 165 points, the Dow Jones Industrial Average (DJINDICES:^DJI) managed to finish at a record high. But modest declines for the S&P 500 (SNPINDEX:^GSPC) and Nasdaq Composite (NASDAQINDEX:^IXIC) actually understated the damage in the rest of the market, as a popular measure of small-cap stocks plunged nearly 3% on the day.

Index

Percentage Change (Decline)

Point Change

Dow

+0.30%

+98

S&P 500

(0.09%)

(3)

Nasdaq Composite

(0.60%)

(79)

Data source: Yahoo! Finance.

2021 has been a bad year for hedge funds, as the WallStreetBets short-squeeze debacle back in January showed the vulnerability of these highly leveraged investment entities. Over the weekend, investors got details on what happened in the downfall of yet another Wall Street hedge fund. The mistakes the fund made can actually teach any investor about the dangers of making aggressive bets in your portfolio through margin trading.

Image source: Getty Images.

Archegos and a massive margin call

On Friday, Archegos Capital Management got a call no investor ever wants to get. Its lenders had decided to force Archegos to sell off $20 billion in stock in order to meet a margin call on loans they had made to the hedge fund.

According to reports, what prompted the decline was a big sell-off in shares of media giant ViacomCBS (NASDAQ:VIAC). However, the margin call went far beyond that stock, leading to Archegos’ sales in several other stocks. Those included fellow media stock Discovery Communications (NASDAQ:DISCA), as well as London-based internet niche retailer Farfetch (NYSE:FTCH).

A host of Chinese stocks also were subject to Archegos-related selling on Friday. They included internet search giant Baidu (NASDAQ:BIDU), e-commerce company Vipshop Holdings (NYSE:VIPS), Tencent Music Entertainment Group (NYSE:TME), social media player iQIYI (NASDAQ:IQ), and educational tutoring company GSX Techedu (NYSE:GSX).

Some of those stocks bounced back on Monday, but not all of them did. GSX was the big loser, falling another 19% Monday. Vipshop, ViacomCBS, Farfetch, and iQIYI were down another 5% or more, while only Tencent Music managed to post a modest 1% gain.

It could happen to you

Few investors have access to the tens of billions of dollars in financing that Archegos had. But most brokers do offer margin accounts to customers, and if you’re not aware of the rules, investing on margin can get you into big trouble.

The attraction of margin stems from the ability to buy more stock than you can afford with your available cash. Brokers happily lend up to a certain amount of money, charging interest. If stocks you own go up, your profits get magnified by the leverage that margin trading gives you.

But when your stocks go down, your losses are also bigger. Even worse, if the value of your account drops below a certain level in comparison to your outstanding margin loans, then your broker has the right to sell your stock automatically without your consent. Often, you don’t even get to pick what stocks your broker sells to pay off the margin call.

Margin calls tend to happen at the worst possible time, when your account is suffering big losses. They force you to sell low, and if the stock subsequently rebounds, you won’t be able to benefit.

Be careful with margin

Margin can come in handy in limited circumstances, but having substantial margin loans on a regular basis can dramatically increase the risk level in your portfolio. You can invest perfectly well without using margin, and it’ll keep you out of the trouble that caused an 11-figure Wall Street hedge fund so much devastation late last week.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.


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