If you invest $10,000 in a good stock and get a 20 percent return, you'll make $2,000. But what if you could have borrowed another $10,000 to buy more stock and doubled your profits?
When investors borrow money, or buy on margin, they're going for these types of gains. But the strategy is extremely risky.
Buying on margin involves getting a loan from your brokerage and using the money from the loan to invest in more securities than you can buy with your available cash. Through margin buying, investors can amplify their returns -- but only if their investments outperform the cost of the loan itself. Investors can potentially lose money faster with margin loans than when investing with cash.
This is why margin investing is usually best restricted to professionals such as managers of mutual funds and hedge funds. To make the biggest profits, some institutional investors invest more than the cash available in their funds because they think they can pick investments that earn a higher return than their cost of borrowing money.
"Margin is essentially a loan that you take to get more leverage in your investments," says Steve Sanders, executive vice president of business development and marketing for Interactive Brokers Group. Costs for the loans vary considerably, particularly for investors with only about $25,000 in their account. Margin loan rates for small investors range from as low as 1.6 percent to as much as 8 percent, depending on the broker. Since these rates are usually tied to the federal funds rate, the cost of a margin loan will vary over time. Right now, margin rates, along with many other loan products, are generally at historically low levels.
Buying on margin has a checkered past. "During the 1929 crash, there was very little regulation of margin accounts, and that was a contributor to the crash that started the Great Depression," says Victor Ricciardi, assistant professor of financial management at Goucher College in Baltimore.
The biggest risk from buying on margin is that you can lose much more money than you initially invested. A loss of 50 percent or more from stocks bought on margin equates to a loss of 100 percent or more, plus interest and commissions. For example, let's say you buy 2,000 shares of XYZ company with $10,000 of your own cash plus $10,000 in your margin account at a cost of $10 a share. That's a total of $20,000, excluding commissions. The next week, the company reports disappointing earnings and the stock drops 50 percent. In that scenario, you lose all of your own money, plus interest and commissions.
In addition, the equity in your account has to maintain a certain value, called the maintenance margin. If an account loses too much money due to underperforming investments, the broker will issue a margin call, demanding that you deposit more funds or sell off some or all of the holdings in your account to pay down the margin loan. "If markets or your overall positions decline, your broker can liquidate your account without your approval. That's an important downside risk," says Ricciardi.
Even those who advocate buying on margin in some situations despite the risk warn that it can amplify losses and requires earning a return that exceeds the margin loan rate. "Margin trading is for experts who understand the mechanics of it -- not your average retiree," says Ricciardi.
Of course, if an investment purchased on margin does well, the gains can be richly rewarding.
Besides using a margin loan to buy more stock than investors have cash for in a brokerage account, there are other advantages. For instance, margin accounts offer faster and easier liquidity. "For most of our clients, we like to have a margin account even if they never buy stocks on margin because they can transfer money faster," says Tom Watts, chairman of Watts Capital Partners, a broker-dealer offering financial services to clients.
For example, investors can usually only withdraw cash from a stock sale three days after selling the securities, but a margin account allows investors to borrow funds for three days while they wait for their trades to clear.
"With a margin account, they don't have to wait: They can access cash instantly," says Watts. "You still have to pay interest for those three days, but it's minuscule." For instance, a margin loan of $10,000 at 5 percent interest would involve interest costs of less than $2 per day.
Watts says his more active clients use a margin account to borrow money to invest with, but he warns that such an investment strategy is best left for a full-time trader.
"If you're in front of your terminal every day, you have strict loss limits and you have a trader mentality, margin investing can be a great thing in up markets. But investors should only do it when the market is going to keep going up and have very strict loss limits," says Watts.
The problem is not knowing when the market might suddenly reverse course, he adds. "If you have a major disruptive event, prices can move pretty quickly against you, and you could end up owing a lot of money in a couple days. Anyone who invests on margin needs to keep a close eye on their portfolio, every day."