In general, buying stocks on margin is a bad idea. However, the idea of buying stocks on margin has increased due to a long bull market and a drop in interest rates. More people are trying to get rich as quickly as possible thanks to what we see and hear on the internet.
Let’s quickly review why buying stocks on margin is a suboptimal move. We’ll then go through some terminology, a couple of margin-buying examples, and the dreaded margin call.
Why Buying Stocks On Margin Is A Bad Idea
1) You become an active investor.
If you buy stocks on margin, this means you are speculating as an active investor. We already know that over the long run, active investors perform horribly compared to passive index investors.
It’s OK to invest a minority portion of your assets in individual stocks to find the next multi-bagger winner. However, unless you are a professional investor, chances are high you will underperform because even most professional investors underperform.
2) Magnifying underperformance.
Given active investors tend to underperform, buying stocks on margin means an investor is magnifying their underperformance by going into debt to buy stocks.
Using margin to buy stocks when stocks are going up works well until it doesn’t. The average investor tends to be too emotional for his or her own good.
3) Going on margin costs money.
Not only is buying stocks on margin likely magnifying your underperformance, there’s a borrowing cost associated with going on margin. The cost to go on margin can range anywhere between 2% – 8% on average, despite the Fed Funds rate and the 10-year bond yield near record-lows.
Therefore, the main people or institutions who are in favor of investing on margin are the brokers or brokerage firms who earn interest off your margin debt.
4) You may get more emotional (stressed).
Given your gains and losses are amplified when you buy stocks on margin, you might become an emotional wreck during particularly volatile days. Your mood swings may negatively affect your relationships with your partner and children.
Taking out your frustrations on innocent loved ones is one of the worst things an investor can do. It’s already difficult to compartmentalize a bad day at work with your home life. It’s practically impossible if you have a bad day at work and a bad day in the market on margin.
If you don’t get a sense of joy when your stocks go up during good times, you will feel the pain of losing money much more during bad times.
5) You might be forced to sell your position at the worst time.
If you buy stocks on margin instead of with 100% cash, your positions are at the mercy of the brokerage that lends you money.
To maintain your margin amount, brokerage firms require a minimum amount of collateral value. If your stocks tank like back in March 2020 when the S&P fell by 32%, your brokerage firm may issue a margin call.
And if you can’t come up with additional capital, your brokerage firm will sell your stocks to meet the minimum collateral requirement.
The Desire To Buy Stocks On Margin Is At An All-Time High
Even after I’ve made the case that buying stocks on margin is a bad idea, it’s good to learn how margin works. Because I know some of you will buy stocks on margin anyway.
Let me share an example. My friend makes roughly $70,000 a year. He helped me get into Tesla stock in 2018, which I am grateful for. Tesla has been one of the best growth stocks of our time.
As we got to discussing the future of Tesla one day, he revealed to me he bought more stock on margin. Given the rise in Tesla stock, I thought he had about a $250,000 position in Tesla, which was already a lot based on his income.
When I asked him how many shares he owned now, he said, “Over 1,000!” In other words, at one point, he had about $900,000 worth of Tesla stock!
I’m not sure how he keeps getting new funds or how much he can borrow from his brokerage account. However, he did say he “only has to pay a 7% interest rate on his margin.”
No matter how hard I try to encourage him to de-leverage, he won’t. He’s adamant Tesla will continue to fly to the moon (I hope so). He needs to get rich. At 38, he wants to achieve financial freedom now!
Meanwhile, the stock crashed 22% from its 2021 high. But on margin, his decline may temporarily be closer to negative 30% – 44%. Losing $200,000+ on paper seems like a lot for someone who only makes ~$70,000 a year. We’re both hoping Tesla bounces back as I was down about $55,000 at one point too.
But when I asked him what next, he responded, “We’ve seen worse corrections before. I’m buying more!”
He truly has “diamond hands.” I’m impressed with his conviction, which is what it takes to get rich.
Investing FOMO is the most difficult type of FOMO to overcome. Unfortunately, I’m sure many retail investors are margined-up. And when the great unwind comes, it is going to be FUGLY!
How Does Margin Investing Work?
Just like a bank can lend you money if you have equity in your house, your brokerage firm can lend you money against the value of certain stocks, bonds, and mutual funds in your portfolio.
That borrowed money is called a margin loan. The margin loan can be used to purchase additional securities or to meet short-term lending needs not related to investing.
In my friend’s case, he decided to go on margin to buy more of one stock that already takes up a 90% weighting in his entire portfolio. Going on margin to buy a stock is one thing. Going on margin to buy more stock that already dominates your net worth is another level of dangerous.
When we discuss going on margin, this is only for your taxable brokerage accounts. You can’t borrow funds in retirement accounts or custodial accounts.
The main reason why is because the government ALSO doesn’t want you to blow yourself up. Margin investing is not risk-appropriate for your financial future.
How Much Can You Margin?
In general, after signing a margin agreement, a brokerage customer can borrow up to 50% of the purchase price of marginable investments. When people say they are on 50% margin, it actually means they’ve purchased double their cash buying power in stocks.
The 50% margin terminology can be confusing, so let me share with you an easy example.
Let’s say you have $100,000 in cash in a margin-approved brokerage account. Your margin agreement says you can borrow up to 50% of the purchase price of marginable investments. You love Apple stock and want to buy more than a $100,000 position.
The margin agreement says you can buy up to $200,000 in Apple stock – you would pay 50% of the purchase price and your brokerage firm would loan you the other 50%. This is where the 50% comes in.
Being able to invest 50% on margin actually means you have double the cash-buying power in your brokerage account. You have a 2:1 margin.
The amount you can borrow (margin) changes every day because the value of your marginable securities as collateral fluctuates daily. Therefore, don’t just assume you have X amount of buying power. Check first before making an investment.
If you run your margin limit to the maximum, a decline in your portfolio’s value will decrease your margin buying power and vice versa.
The Parallel To Using A Mortgage To Buy A Home
The 50% margin figure is like having a 50% loan-to-value ratio when buying a home.
Isn’t it funny how it’s totally acceptable for people to buy a house with up to an 80% loan-to-value ratio (20% down, 80% loan)? Whereas, when it comes to buying stocks on margin, it’s considered much riskier.
Understanding this difference is important for understanding risk and how you want to construct your net worth allocation.
If the government prohibits retirement accounts from using margin, online brokerage accounts limit margin investing to 50%, and the government encourages only 0% – 3% down payments for first-time home buyers, we can conclude real estate is a less risky asset class.
It is unlikely that a property’s value will decline by 32% in a month like the S&P 500 did in March 2020. During that month, you can bet your bottom dollar that plenty of investors on 50% margin either received margin calls or were forced to sell some of their margined positions. If margin investors didn’t get back in, they are crying now for missing out on a huge rebound.
On the other hand, if real estate investors kept paying their fixed mortgage payments each month, nothing happened. Further, a tangible asset like real estate outperformed when stocks were getting crushed.
More On Margin Interest
Buying the S&P 500 index on margin is a more risk-appropriate investment than buying single stocks on margin. However, even still, if it costs 2%+ year to go on margin, the investment arbitrage is difficult. However, if it cost <2% to go on margin, there would be a surge in margin investing.
Margin interest cost is what keeps the most risk-loving investors in check. Margin interest rates are almost always lower than credit cards and unsecured personal loans. However, that doesn’t mean margin interest rates are low.
Even in a low-interest rate environment as we are in today, margin interest rates are usually between 2% – 8%. And if interest rates start going up, margin interest rates will go up as well.
There’s no set repayment schedule with a margin loan. Monthly interest charges accrue to your account. You can repay the principal whenever you wish. Also, margin interest may be tax-deductible if you use the margin to purchase taxable investments and you itemize your deductions.
How Margin Can Boost Returns
Investors buy stocks on margin to try and boost returns. Margin investors are so certain of a stock’s potential that they are willing to go into debt to try and earn a return much greater than the margin interest rate.
Let’s say you use $100,000 to buy 10,000 shares of a $10 stock. A year later, the stock rises to $15. Your shares are now worth $150,000. Not one to get too greedy, you take profits for a $50,000 gross profit or 50% return.
But what would happen to your gain if you went 50% on margin? Your $100,000 could have bought you 20,000 shares at $10, or $200,000 worth of stock. A year later, your 20,000 shares are worth $300,000 and you sell. Therefore, your gross gain is $100,000 for a 100% return after paying back the $100,000 you purchased on margin.
Even though you had to pay a 7% interest on the $100,000 margin loan equal to $7,000, your net gain before taxes is still $93,000 for a 93% return. Wow! Margin investing sounds awesome!
The Negative Of Margin Investing
Let’s say you buy 20,000 shares of a $10 stock on margin for $200,000. Instead of the stock appreciating by 50% in a year, it declines by 50%. Your 20,000 shares are now worth only $100,000. Given you started with $100,000 in cash and lost $100,000 on margin, you end up with a negative 100% return! You are wiped out!
What’s worse, you also owe the brokerage company $7,000 in margin interest. Therefore, you’ve not only lost everything, but now owe money. The brokerage firm wins. You lose.
The Dreaded Margin Call
To protect itself, an online brokerage will have a margin call. Think about the margin call as an equity buffer for the online brokerage. The online brokerage knows that some investors will run out of money and not pay their margin interest.
Therefore, to help ensure the online brokerage stays profitable while margin lending, it has a minimum equity requirement as collateral value.
The minimum equity requirement for a margin loan is usually between 30% to 35%, depending on the type of securities the investor holds and the brokerage firm. If the collateral equity value declines below this percentage, the investor will receive a margin call.
If you receive a margin call (maintenance call), you must deposit enough cash to be above the minimum equity requirement. Otherwise, your online brokerage has a right to sell your securities to fulfill the requirement.
Margin calls only happen when your margined investment is tanking. And if you can’t come up with the cash, then you might end up selling your leveraged investment at a terrible time. Buying high, selling low is a way to poverty.
Margin Call Example
Assume you own $100,000 in stock and buy an additional $100,000 on margin, resulting in 50% margin equity. You are borrowing the maximum allowed by your brokerage.
Let’s say your stock falls by 40% from $200,000 to $120,000. Your equity would drop to only $20,000 ($120,000 in stock less the $100,000 in margin debt you still owe).
If your brokerage firm’s maintenance requirement is 30% (30% of $120,000 = $36,000), you would receive a margin call for $16,000 because you only have $20,000 in equity.
If you can’t come up with the $16,000 in cash within a certain amount of time, the brokerage firm may be forced to sell enough equity to reach the maintenance requirement of 30%.
In this case, the brokerage firm might have to sell about $53,334 in equity AFTER it has declined by 40% for you to meet the maintenance requirement of 30% if you can’t come up with $16,000 cash.
If you only have $20,000 in equity with a 30% maintenance requirement, the most exposure you can have is $66,666 (= $20,000 / 30%). Therefore, $120,000 – $66,666 = $53,334.
But, if the stock continues to decline, despite selling $53,334 in equity, the online brokerage firm will still have to sell more equity at a loss for you to meet the 30% maintenance requirement!
This type of death spiral is what helps accelerate panic selling. People panic because they see other people being forced to sell due to margin calls. And what’s more, hedge funds can often borrow even more than typical retail investors through their prime broker.
If everybody is long or short in a particular security, massive movements tend to occur and compound on themselves.
Use Margin Sparingly Please
Margin loans increase your level of market risk. Your downside is not limited to the collateral value in your margin account. You could lose everything, have to come up with more cash, and lose that amount too. Further, you will have margin loan interest to repay.
Margin calls happen when things are going really bad. You are not entitled to an extension of time to meet a margin call. Therefore, your online brokerage account will force a sell at the most inopportune time if you cannot come up with the cash.
Again, the only people who may be fine with you going on margin to buy stocks are those working at a brokerage firm. Instead of buying stocks on margin, buy stocks with cash only. If you want to buy more stocks, make and save more money.
Buying stocks on margin is only profitable if your stocks go up enough to pay back the loan with interest. However, with margin interest rates multiple times higher than the risk-free rate of return, your net returns will likely be uninspiring.
If you want to buy stocks on margin, you may consider it during the next bear market after stocks decline by greater than 20%. But, when stocks are expensive and priced for perfection, going on margin is risky. A swift downturn could easily wipe you out.
The only time where margin can be useful is covering you during slow ACH transfers or when you’re mailing in funds. If the market takes a big dip while you’re waiting for your funds, and you want to get in, you can use margin for a few days to buy stocks. Other than that, margin investing isn’t worth it.
Readers, do you buy stock on margin? If so, have you ever had a margin call or be forced to sell securities? Why do you think banks enable homebuyers to borrow so much more than stock investors? Are you concerned about the amount of margin investing today?