THE MONEYPAPER
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Margin Investing: Use with caution
Vita Nelson: "Investing on margin puts the wind to your back in a bull market but makes your stumbles more painful during a downturn.
Using margin means borrowing from your broker rather than from your banker. Interest rates on such loans are reasonable, especially when compared with the rates on credit cards.
Margin interest rates are generally 0.5% to 2% above the "broker's call" rate (now 7%). Thus, margin rates currently range from 7.5% to 9%, with the lowest rates reserved for loans over $50,000.
You can use a margin loan for any purpose, from paying your child's college tuition to financing a vacation. Some people prefer the convenience of a broker's margin account to filling out a bank's forms. But margin loans are used mostly to invest in more securities.
For most securities, the maximum margin allowed is 50%. You can borrow up to $100,000 on margin if you have $200,000 worth of stocks, bonds, and mutual funds.
Although the Federal Reserve and the New York Stock Exchange set the basic regulations, each brokerage has it own rules. For instance, some firms don't allow margin on stock selling for less than $5 and certain volatile issues. In addition to such restrictions, which vary from firm to firm, in general, investors can't use margin in tax-deferred retirement accounts.
Long term (since 1925), large-company U.S. stocks have gained more than 10% per year. For the past 25 years, that annualized return has been nearly 13%. Some people conclude that it makes sense to pay 7.5%-9% per year in order to buy stocks that likely will earn 10%-13% per year. They reason that over the course of decades, boosting returns in this manner can add substantially to their net worth.
The tax code makes this strategy even more appealing. If you borrow to buy securities and you report substantial amounts of taxable investment income, you probably can deduct your margin interest. Thus, on an 8% margin loan, you'd only pay around 5.5%.
Moreover, any stock market gains can remain untaxed for years-until you cash them in, when they may be taxed at favorable long-term capital gains rates. Thus, if all goes well, you can borrow at 5% or 6%, after-tax, and eventually realize gains of 8% to 11%, after-tax."
The catch is that things may not go well. Stocks do not go up every year, and certain stock don't go up at all. While stocks go up or down, margin interest is a cost that's incurred steadily.
Indeed, investing on margin makes a portfolio more volatile. Highs are higher, but lows can be disastrous. Even in a flat market, the costs of leverage will hurt you.
Suppose, for example, you invest $20,000 in stocks, using $10,000 worth of margin, and those stocks fall by 20%, to $16,000. You'd still owe $10,000 to your broker, so your equity has fallen to $6,000 from $10,000. On a 20% drop in your stocks, you've suffered a 40% loss of principal! To make matters even worse, the loss may trigger a "margin call." (Policies differ from firm to firm but many brokers have an informal rule that a 28% drop in a 50% margin account will generate a margin call).
When you receive a margin call, you'll be asked to add more cash or more securities to your account, to re-establish your 50% position. If you don't comply swiftly, the brokerage firm will sell enough securities from your portfolio to protect its collateral.
Investing on margin can be risky but there are some ways to reduce your exposure. Instead of a 50% margin, you might use a 20% or 25% margin. That is, use $15,000 or $16,000 in cash instead of $10,000 to buy $20,000 worth of stock. You will reduce the risk of a margin call and still have the potential for boosting your long-term returns.
You might use margin to add diversification to your portfolio, which can be described as a risk-reducing strategy. Suppose, for example, your portfolio is heavily weighted toward one stock. If that stock should fall sharply, your net worth would be depressed. You'd like to sell shares and invest elsewhere, but your position is so highly appreciated that any sale will generate a substantial tax obligation.
In this situation, you could borrow on margin and use the proceeds to diversify. Borrowing the money won't trigger a tax bill, and the interest payments may be deductible.
If the other securities you acquire increase considerably in value, you'll benefit from the appreciation. If those securities lose value, you can harvest capital losses and take offsetting gains on the concentrated position, without having to pay tax.
Margin can serve as an emergency source of credit when money is needed to fund some special situation. You may have an unexpected tax bill to pay or an investment opportunity might look attractive. To raise the cash, you may want to sell a certain security but that security may be showing short-term gains. By using margin to bridge the gap, you might be able to hold the security until it qualifies for the 15% rate.
The bottom line is that margin can be useful too, but it must be used with caution."
