Margin Benefits are Marginal at Best

Margin is one of those things that novices find puzzling about the stock market, but the concept is really quite simple. Still, with understanding the basics of using margin accounts, determining the wisdom of using margin can be quite a conundrum.

A margin account is a traditional investment account with margin privileges.

This means your broker has set up what amounts to a line of credit secured by the stocks and bonds in your account. Often this margin credit line is used to buy more stocks in the same account. But the account can also be borrowed against to buy real estate, make other kinds of investments, or simply to pay personal bills. The simple requirement is that enough assets must be kept in the account to maintain a certain value as collateral for the loan.

This is where trouble comes in. It's easy enough to maintain that collateral level when all is well, but when the economy becomes difficult and you are strapped for cash, this is also often the time when the market may drop. When the market drops temporarily, your equity value may fall, but the value of your debt doesn't change; you may encounter a "margin call" when you can least afford it.

A margin call is similar to any other loan being called in. You must pay up immediately. If you don't have the cash, your stocks and bonds are sold automatically to pay your debts. This compounds your problem: you end up selling your stocks when they are down, usually the worst possible time. Remember, the idea is to buy when prices are down and sell when they are up. So, in addition to all the other problems, margin loans can force you to make poor investment moves. In times of market crashes, a heavily margined account might be completely lost when the market drops only a fractional amount.

This leads to the idea of leverage, which is what margin accounts represent. Anytime you borrow to invest, you leverage your investment, or buying more than you can afford for a fractional down payment. Since one is buying stocks with borrowed money, or borrowing against stocks already owned, this is the result. Buying a home with a mortgage is a very similar process, but since the bank doesn't typically call your loan if home prices dip temporarily, many of the problems listed above do not arise. Still, a 95% mortgage is a highly leveraged deal, and it is very easy to lose your entire investment with even a small change in real estate prices. Even a typical 80% mortgage can wipe out the entire investment in a poor market.

Despite the many risks associated with margin or other forms of leverage, there definitely are advantages. Certainly, we've emphasized the opportunity to lose money faster, but you can also make money faster using these tools. If half of your equity comes from margin, you can gain money twice as fast. As stocks go up, your profits are compounded, because you own twice as many shares as you could normally afford. Thusly, when the market drops, you lose twice as fast.

Also, some people benefit simply by having a margin credit line available, without making use of it at all, or by only using it for short-term turnover. If used judiciously by a disciplined investor, there is virtually no risk in having access to a margin account. It is the use of the debt obligations that carry the costs. Imagine having a credit card that is never used, but the credit line is available in case of major emergencies.

In the end, leverage simply means that your gains or losses will be multiplied. Each investor must consider for him/herself the acceptable level of risk. However, we firmly believe that there are other risks, which carry better payoffs than simple use of leverage. While it is good for most investors to have access to margin, it may not be wise to use it often. In addition to interest costs, the added risks may end up causing more harm than good.

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Scott Pearson is an investment advisor, writer, editor, instructor, and business leader. As President and Chief Investment Officer of Value View Financial Corp., he offers investment management services to a wide variety of clients. His own newsletter, Investor's Value View, is distributed worldwide and provides general money tips and investment advice to readers both internationally, and in the U.S.