When investing in the stock market, it is common to think that you would be able to make much more money if only you had more money. I mean, 10% gains on $100,000 are way more than 10% on $50,000. There is a way to do this, and it is called margin investing.
In short, I don’t think that margin investing is a great idea for beginner investors. Read more below to see my reasons.
This post will cover margin investing and whether you should consider utilizing it.
What is Margin Investing?
When you invest with a margin, this means you are borrowing, aka loaning, money from an entity to invest with. Usually, this entity will be whatever broker you use to invest in the first place. If you invest through Fidelity, Fidelity will loan you an amount of money for you to invest with.
This loan is combined with your deposits to calculate your buying power. Buying power is the amount of money you have available to invest.
Not every brokerage offers margin accounts. Make sure to do your research on whether your desired brokerage offers them.
What is Required to Invest with a Margin?
Different brokerages have different rules, but you will need to have enough collateral on your account to invest on margin. If you fail to pay them back and your margin investments go to zero, you need to have enough funds to cover their losses. At this point, they will sell your other investments to cover the margin you had used.
You will also need a margin investing account to utilize margin investing. You can obtain one by applying for one once you have opened your standard investing account. There will also be a minimum account value of $2,000 before applying, though this could be higher at some brokerages.
Brokerages tend to limit the assets you can purchase on margin. For example, they will likely restrict you from buying extremely cheap, volatile stocks. These assets are too likely to decrease drastically, making it harder for the brokerage to get its money back. Brokerages want to give margins to safe investors who will likely pay them back.
Once you have obtained a margin, you will also pay interest. This interest must be paid by its due date, or the brokerage will take the value of the interest out of your account. Pay your interest on time to stay in good standing with your broker.
How Much Margin Can I Get?
To obtain a margin, you need to deposit 50% of the purchase price of the assets. So, you can get an amount of margin equal to the value of your account.
This available margin will fluctuate based on the value of your investments. If the overall value of your account drops by 5%, your available margin drops by 5%.
How Does Margin Investing Differ from Normal Investing?
Leverage is the ability to purchase assets partially or entirely with funds supplied by a lender. Margin investing gives you access to additional funds through loans. This increases your investing leverage.
In a regular investing account, your leverage is 1:1. You can only purchase assets with the money you deposit. On the contrary, in a margin account where you must deposit 50% of the asset price, you have 2:1 leverage. You can purchase assets twice the value of your deposit since the broker covers half.
As mentioned, these investments are also restricted to ensure they aren’t too volatile or risky. However, this only applies to assets purchased with a margin. If you have $2,000 in buying power with 2:1 leverage, you don’t start dipping into your margin until you buy more than $1,000 in investments. So, you can invest $1,000 in riskier assets before you are restricted.
Margin Call
The brokerage will require you to keep a certain amount of funds in your account, called a maintenance margin. You will be issued a margin call if you fall below this threshold. A margin call is a requirement by the brokerage for you to deposit more money. If a margin call is not fulfilled, the brokerage will sell your assets until it reaches the maintenance margin again.
When signing up for a margin account, make sure to find out the maintenance margin.
Should You Use Margin Investing?
Pros of Margin Investing
Magnify Your Gains
When you use margin investing, you are adding your margin to your deposited funds to find your buying power. With a higher buying power, you can purchase more investments.
The greater the value of your investments, the greater the dollar value of percent changes in your account. If you have a buying power of $10,000 and invest it all, a 10% return would get you $1,000. If you increase your buying power to $20,000 using a margin, you can double your gains to $2,000.
Increased buying power means an increased ability to generate gains in actual dollar value. Investing with margin won’t change the percent return you get, only the dollar value.
Increased Leverage
Remember, these doubled returns were obtained with the same initial investment of $1,000. This is the power of leverage. You can use more money to generate higher returns without investing additional funds.
Leverage is arguably even more powerful for wealthy people. Wealthy people use their massive portfolios to access unbelievable leverage. For example, a person with a $1 million investment portfolio would have access to $1 million in margin. This leverage allows them to earn $200,000 on just a 10% return in the market.
Additional Compounding
The margin accessible to you is not a set value. It increases and decreases along with your portfolio. So, if you can use the margin to generate greater returns, you can use these additional returns to purchase more assets. Now, you have more collateral since the value of your investments is greater. Thus, you can now borrow evenmore margin.
This can compound on itself forever, with greater returns increasing your available margin generating even greater returns, and so on. Compounding is the most potent aspect of the market. But margin investing adds an additional layer to this.
Jump on Opportunities
If you see an opportunity in the market and think a company is going to increase rapidly, you may want to invest more in that company. You must wait to deposit those funds in a regular investing account. This could take a while if you must dip into savings or wait to earn it, at which point the opportunity may be gone.
However, with a margin account, you could immediately dip into your margin and use that to invest. You could jump on an opportunity at a moment’s notice without having to wait for more funds. This can be a powerful tool if you don’t hold the company too long and pay too much interest.
Cons of Margin Investing
Magnify Your Losses
Sadly, we have to consider the possibility that your portfolio doesn’t always trend up. Every investor makes poor investments, and sometimes (like right now), the entire market is down. During times like these, investing with a margin magnifies your losses even further.
If you lose 10% of $10,000 in buying power, that is far more than losing 10% of $5,000. These losses can hurt if you use the margin to make short-term trades, as you now have to make up for selling at an increased loss.
Paying Interest
You must pay interest like any other loan when you purchase with a margin. This interest rate varies by brokerage but is usually 3-10%.
When you select a brokerage, keep this interest rate in mind. To make any money with margin investing, you need to generate greater returns on your invested margin than your interest rate.
For example, let’s say your interest rate is 7%. If you invest this margin and generate 7% returns, you break even since you must pay all your returns back to the brokerage in interest. You start making additional money off your margin once you earn 8% or greater returns. So only invest with a margin when you are confident that you can generate returns higher than your interest rate.
As I mentioned above, investing with a margin won’t increase your percent rate of return, only the dollar value. Thus, don’t invest with a margin if you can’t generate returns greater than your brokerage’s interest rate. Your percent returns will stay the same, and you will lose money.
Because of interest, the margin is usually used for short-term investments. This limits the amount of interest you owe. Short-term investing is inherently riskier since the market is more difficult to predict in the short term than in the long term.
Increased Stress
Assuming you aren’t a robot, stress is a part of investing. If you are a robot, welcome to the blog.
It’s stressful to use your money to invest in companies and hope they increase the value of your investment. This stress varies by how confident you feel about your investment and how volatile the stock is.
This stress is magnified when you know you are investing with borrowed money. Suppose you lose your own money, big whoop. You have to work to replace it over time. However, if you lose someone else’s money, like your brokerage, you now have to pay back those losses.
I tend to preach emotionless investing. When we invest too much using our emotions, we make decisions based on our feelings more than solid facts. This style of investing usually leads to more losses than gains.
I don’t say this to scare you away from margin investing. I want you to realize the possible stress it will add to your investing experience. Being aware of this makes you more prepared to deal with it.
Margin Example
Let’s imagine you deposit $10,000 in your margin account. Assuming you have standard 2:1 leverage, you now have access to $10,000 in margin, giving you $20,000 in total buying power.
You still haven’t tapped into your margin if you purchase $10,000 worth of assets. At this point, you pay no interest and are not restricted on the investments you can make. If you purchase an additional $3,000 of assets, now having invested $3,000 worth of margin, you begin paying interest. If your interest rate is 5% annually and you hold the investment for five days
5% x $3,000 = $150/year
$150 / 360 (# days used by brokerages) = $.41/day
$.41 x 5 = $2.05
You would have to pay $2.05 in interest to loan $3,000 for five days. Let’s say you made 6% gains on your investment during those five days
6% x $3,000 = $180
$180 – $2.05 = $177.95
Once you paid the interest, you would have made $177.95 off this investment.
Final Decision
There is no hard and fast rule about whether margin investing is a good idea. It comes down to whether you can find short-term opportunities where increased leverage would help you.
In my opinion, for most investors and beginner investors, margin investing is not a great idea. As an investor investing in companies, you don’t see inside of day-to-day, it is impossible to know what is going to happen in the short term. It is a huge risk in the first place, amplified by the fact that you are investing using borrowed money.
It could be detrimental if you invest with margin at the wrong time in the wrong company. Your brokerage could give you a margin call and sell your other assets to pay themselves back. Now you have lost the margin you invested and some of your assets that weren’t even involved in the failed trade.
If you are a more seasoned investor with a company or two you feel comfortable predicting in the short term, this could be a different story. You would generate gains beyond what would have been possible by yourself. I recommend understanding your capabilities and not overstepping. Sometimes, the upside doesn’t outweigh the downside.
The riskiest investments are investments where you don’t understand the risk. By reading this post and reading into your brokerage’s margin requirements, you are doing your part to understand the risks of margin investing.
Margin investing can take your portfolio’s performance to the next level. Best of luck whether you decide to utilize margin or not.
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