A Look At Margin
Margin is a loan from your brokerage for the purpose of buying more stocks than you otherwise would be able to purchase using the amount of cash you have on hand.
To use margin, you must apply and be approved to open a margin account by your brokerage. A margin account is different than the standard cash account that most investors first start using.
As there is risk involved, the brokerage charges interest for the loan and the collateral for the loan is any cash and stocks in the account.
Once approved, money can be borrowed from the brokerage and then be used to purchase additional shares on the stock market.
Most brokerages allow margin account holders to borrow up to fifty percent of the total value of the cash and stock holdings in their account.
Use Of Margin
Short-term stock traders often use margin in the hope of improving their stock market returns. However, margin is usually avoided by long-term investors as over an extended period, a greater return would be necessary just to break even.
Traders often target stocks with more volatile price swings. As they focus on shorter time spans than investors, short-term traders need to use margin to magnify the size of those price swings to try and make a profit.
Strictly speaking, margin, the borrowed money in the account, is invested by the account holder to create leverage.
In other words, the borrowed money is used to purchase additional shares of companies in an attempt to increase returns.
However, in colloquial English, the terms margin and leverage are often used interchangeably.
Just like using a lever to make the lifting of a heavy object easier, short-term traders often use borrowed money to create leverage to try and increase their stock market returns.
How Leverage Works
If you buy a stock for $100 using your cash, and the price goes to $150 and you sell, then you make 50% on your investment.
On the other hand, if you buy a $100 stock using margin, $50 of your money and $50 of money loaned from your brokerage, then if the stock goes to $150 and you sell, you make 100% on your investment. Although you will still have to pay your broker back the $50 you borrowed and any interest.
Now let’s look at the opposite scenario. Stock market prices don’t always go up.
If you buy a $100 stock using only your money, and the stock price goes down to $50, and you sell, you lose 50% on your investment.
However, if you buy a stock for $100, this time using $50 of your money and $50 of money loaned from your brokerage, then if the stock price drops to $50 and you sell, you lose 100% on your investment. You would still be required to pay back the $50 loan to the broker and any interest due.
Margin Costs Money
Naturally, a brokerage is not going to loan you money for free. Using margin costs money. Your brokerage will charge you a fee.
For example, for a loan balance of under $10,000 U.S., at the time of writing, the discount retail brokerage firm Scottrade will charge an interest rate of 8% annually.
This amount is not an insignificant sum of money to charge for a loan. The stock market as a whole has only had an annualized rate of return of between six and seven percent after being adjusted for inflation.
Margin Is Risky
The noted value investor, author, and founder of The Baupost Group, Seth Klarman has warned against using margin to create leverage:
“Almost every financial blow up is because of leverage.”
Although it is indeed possible to increase investment returns by using leverage, it significantly increases risk and the possibility of significant losses as well, as author James Montier explains:
“Leverage is a dangerous beast. It can’t ever turn a bad investment good, but it can turn a good investment bad. Simply piling leverage onto an investment with a small return doesn’t transform it into a good idea. Leverage has a darker side from a value perspective as well: it has the potential to turn a good investment into a bad one! Leverage can limit your staying power, and transform a temporary impairment (i.e., price volatility) into a permanent impairment of capital.”
When it comes to trading with margin, the biggest risk is if you buy a stock and the price drops, because the amount of money you owe the brokerage stays the same.
Let’s go back and take a look at the case of buying a $100 stock again.
As was previously shown, if you purchase a stock with your cash, the stock price goes to zero, and you sell, the most you can lose is 100% of your money. While that is certainly terrible, it could be much worse, believe it or not.
For example, if you buy a $100 stock using $50 of your money, and $50 of margin and the stock goes price goes all the way to zero, you lose 150% of your money.
You read that right. You can lose more funds than you have invested. It is possible to lose both your money and the brokerage’s money as well.
Of course, you will still be required to pay back the $50 you borrowed from the broker and any interest due. The use of leverage can lead to truly disastrous results.
One of the biggest problems with margin is that the brokerage, at any time, can demand that you deposit more money in the margin account to cover the loan.
Nowadays, although it often comes in the form of an email from the brokerage, it is still known as the dreaded “margin call.”
The stipulation for the account holder to maintain a particular total equity percentage requirement, known as the maintenance margin, is written into the contract that was signed before approval for a margin account.
If you don’t deposit more money into the account within the next few days, the brokerage will sell some of the stocks in your margin account so that you meet the required maintenance margin.
While investors are free to gamble with their money, brokerages will make it a point to protect their assets carefully from possible investment loss.
A margin call usually happens at the worst possible time as well, when stock prices are falling and bargains abound.
Although it has been incorrectly attributed to numerous people over the years, the following proverb illustrates this situation well:
“A bank is a place where they lend you an umbrella in fair weather and ask for it back when it begins to rain.” – Anonymous
The same is certainly true when borrowing money from a brokerage. When the stock market is rising, a broker is more than happy to loan you money, but when stock prices fall they suddenly want their money back.
Margin is very seductive. When everything is great, and stock prices are rising, it is easy to fall in love with it. However, once life gets tough and traders start to panic, the use of leverage quickly turns into a financially damaging short-term love affair.
Drama In The Market
Margin is one of the reasons why stock market selloffs can be so dramatic. Short-term traders who are using leverage, suddenly get margin calls and are forced to sell some of their stocks to cover their loans during a stock market panic, regardless of the underlying companies are fundamentally sound businesses or not.
When a fire alarm sounds at a movie theater, the audience panics and runs for the exits. In a similar fashion, when stock prices fall, short-term traders who are jacked up on leverage panic and run to exit the stock market.
It doesn’t make much sense, does it? When share prices drop, that is the best time to be buying more. As Mark Yusko, the founder and Chief Investment Officer of Morgan Creek Capital Management, has observed:
“Why is investing the only business where when things go on sale everyone runs out of the store?”
However, if you are a short-term trader using leverage when stock prices drop, you don’t have any other choice. The brokerage will demand that you immediately add more money to meet you required maintenance margin or else they will sell some of your stocks whether you like it or not.
In a situation like that, not only did you miss the best time to be buying stocks, but you were forced to sell your stocks at the worst possible moment.
If the stock price fell quickly and cash and money gained from the sale of the shares in your brokerage account were not enough to pay back the loan, then your stock investments will be a total loss, and you still have to pay back the rest of the loan and any interest.
Stock Prices Fall
Stock prices fall. Quite regularly actually.
As financial writer Morgan Housel has explained, there is a 10% dip in the S&P 500 about every 11 months. A 15% drop happens about every 24 months. A 50% drop? Two or three times a century.
Think about that for a moment. As the average lifespan in the U.S. is over 75 years, you should expect to experience a 50% drop in the S&P to happen at least twice during your lifetime, so don’t be surprised the next time it happens.
Not only the market as a whole, but there is also a very real possibility of even a healthy “defensive” company’s stock dropping fifty percent during a panic. Warren Buffett has mentioned that the stock of his holding company, Berkshire Hathaway, has lost 50% four times since the company was founded. However, for those who continued to hold, the price has always recovered over time.
Berkshire Hathaway is known for having a Fort Knox balance sheet and keeps billions of dollars of cash readily available to take advantage of stock market drops like these by buying shares of other companies when they are cheap. However, Berkshire Hathaway ‘s stock price is still not immune from falling when traders and investors panic.
Chance Of Success
There seems to be only a one in three chances of success when it comes to using leverage to buy stocks:
- If the stock price rises and you sell, you win. You can repay the loan, the interest, and trading fees. You make a tidy profit in the end.
- If the stock price stays the same and you sell, you lose. Although the stock price didn’t change, you still have to pay back the loan, any interest accrued while waiting, and the trading fees. You lose some money.
- If the stock price drops and you sell, then not only did you lose money, but you still have to pay for the loan, any interest, and trading fees.
In all three scenarios, in addition to any trading fees, you will be losing at the very least, some money by using leverage, as interest will be accruing on the loan. In other words, no matter what happens, the brokerage always wins in the end.
The best way to protect yourself against a sudden financial catastrophe in the stock market is not to use leverage at all, as arguably the most famous investor Warren Buffet explains:
“The most dramatic way we protect ourselves is we don’t use leverage. We believe almost anything can happen in financial markets. The only way smart people can get clobbered is (if they use) leverage. If you can hold them (the positions you own during a crisis), then you’re OK. But even smart people can get clobbered with leverage – it’s the one thing that can prevent you from playing out your hand.”
Joel Greenblatt, value investor, and adjunct professor at Columbia University, completely agrees:
“You can’t leverage because you need to live through the downturns and that is incredibly important.”
Value investor Seth Klarman has also warned against the use of margin and leverage:
”Value investors have to be patient and disciplined, but what I really think is you need not to be greedy. If you’re greedy and you leverage, you blow up.”
The message of the importance of protecting yourself by not using leverage can be found again and again in the talks and writing of the best long-term investors.
Cooler Heads Prevail
There is a real benefit to never borrowing money or using leverage when investing.
It is important always to keep in mind that the rapid short-term fluctuations in stock price are not an accurate representation of a company’s underlying intrinsic value.
No matter how low stock market prices may fall in the short-term, for the long-term investor who bought their stock using only cash, they can wait out any unreasonable market drop or panic and even take advantage of the situation by purchasing more shares of great companies selling at discount prices.
Little Margin For Error
I’ve never used, nor liked the idea of using leverage. It is far too risky for my personal tastes.
It seems that people who use leverage, want the benefit of investing a significant amount of money, without putting forth the effort to save the money in the first place.
Investing only with cash is much safer than using borrowed money. It prevents the need for forced selling during stock price drops or temporary market crashes and even puts you in a good position to take advantage of those situations.
Most of all, debt is almost never a good thing. Don’t voluntarily introduce it into your investment portfolio.
Using margin to create leverage is hazardous.
If you use leverage and the stock price drops, you can lose more money than you have invested.
Many of the best value investors, like Warren Buffett, have warned about the dangers of using leverage.
If you use leverage, your brokerage can force you to sell your stocks at the worst possible time.
Margin: Borrowing Money To Pay For Stocks
Purchasing On Margin, Risks Involved With Trading In A Margin Account
Understanding Margin Accounts, Why Brokers Do What They Do
Beginner Trading Fundamentals: Leverage And Margin
A Banker Lends You His Umbrella When It’s Sunny and Wants It Back When It Rains
Buffett: It Would Surprise Me If Stock Prices Drop 50% (March 14th, 2014)
What I Plan To Do When The Market Crashes
Compound Annual Growth Rate (Annualized Return)
Leverage Dial: Olivier Le Moal/Depositphotos.com
Scientific Child: Michele Piacquadio/Depositphotos.com