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Today I thought I would have a quick look at what trading on margin is all about, and whether or not it is Foolish. The use of the term blurs the issue of what you are actually doing if you engage in this practice. Let's make it simple: if you trade on margin you are borrowing money, and as we say quite clearly in Step 3 of the 10 steps to Foolish Investing, before you start investing you should GET OUT OF DEBT FIRST!
Trading on margin lets you buy shares on credit, using the value of the shares that you buy or already own as collateral for the loan. Loan rates are much more attractive than evil credit card rates, but you will still be paying interest rates of 4% or 5% over the base rate, which currently means 10% or more. Remember that investing in the stock market has traditionally returned around 12% per annum, so at these levels you don't have much room for error.
Why is margin trading likely to prove popular with investors? Well, it will enable you to bring leverage to bear on your portfolio. Margin can be a way to add some extra return to your portfolio if you think your investments will provide returns higher than the cost of borrowing. There's no free lunch, though. You are also increasing your risk.
Let's say you've got £10,000 to invest. With the maximum margin level likely to be set at 50%, you will be able to buy £20,000 worth of shares through a margin account. By doing this you will have taken on a loan of £10,000, or 50% of your total investment of £20,000. If we assume that you pay your broker a margin rate of 10%, you will end up paying interest on the £10,000 borrowing of £1,000 in the next year. If your £20,000 worth of investment increases by 20% in the next year then the value of your portfolio will be £24,000. If you then sell some shares to pay back the £10,000 loan plus the £1,000 interest, you will still have a portfolio worth £13,000 (£24,000 - £11,000). That is a 30% gain on your cash investment of £10,000, even though the value of the shares you invested in only grew by 20%. That sounds great doesn't it? You can use trading on margin to significantly increase the returns on your portfolio.
Of course, shares don't always go up, and if they fell the losses you incurred would also be increased. Using the same example, investing £10,000 of your own money, and borrowing an additional £10,000, but assuming that the value of your £20,000 investment actually falls by 20% over the year, you would lose £4,000. This would result in you having an investment value of £16,000. You would have to sell some stock to pay back the £11,000 of borrowing and interest, so you would be left with only £5,000. From your original capital of £10,000 you will have lost £5,000, or 50%!
In the US, by law, brokers can let you margin up to a maximum of 50% or your investments. This means that the loan can be as high as 50% of the total value of the cash and shares in your account. If you are margined up to the maximum, and there is a significant drop in the value of your portfolio, this would trigger a "margin call" from your broker to either stump up some more cash, or sell some of your shares. This might have you selling some of your shares at the worst possible time.
Investing with margin isn't an automatic Foolish no-no, in my opinion. But it really should only ever be used with extreme care and moderation. While some people will use margin to borrow up to the hilt, borrowing 50% of the value of their portfolio, that really is far too risky, totally unFoolish and something that any investor is better off avoiding. If you are an experienced investor, and you are attracted to the idea of using margin to try and increase your returns, you should limit yourself to borrowing no more than 20% of your portfolio's value. If you do so and you have £10,000 in your portfolio, you'll be borrowing no more than £2,000 and putting £12,000 to work for you. A little leverage can be useful.
But think very carefully before you use margin. If you're borrowing on margin and paying 10% interest, you should be pretty sure your stocks will appreciate more than 10%, and how many of us can really be certain of that? Only experienced investors should ever use margin. Even then most experienced investors will probably steer well clear of it. I have been investing for about 15 years (and I would not consider myself to be an experienced investor; I am still learning), and I would never borrow money to invest. At least, not directly -- I am doing it indirectly as I am carrying a mortgage while investing as well. I have done pretty well over the last 15 years (OK, in the longest bull market ever, I know!) -- but I have achieved this without having to borrow money (directly). Investing is a risky business; why add extra risk on top?
The real risk with margin trading is that it will increase the likelihood that investors will think they can make a quick profit by trying to buy and sell shares, using margin to increase the leverage. All readers of The Motley Fool know what we think about day trading; it is a recipe for disaster. But fools (note the small "f") will undoubtedly try to use margin trading to increase short term profits on volatile shares, and find that it increases their long term losses.
With the influx of US brokers onto these shores, we are likely to continue to see an ever-increasing liberalisation of share trading. The next thing that will come will be shorting of stocks -- that is, selling shares in a company that you don't actually own, in the hope that the share price will fall. Maybe that can be the subject of a future Fool's Eye View.
Will you trade on margin, and are you looking forward to the day you can short stocks as easily as buying them? Let us know your views on the Fool's Eye View message board.
Related links
Margin Trading and the '"crash of '29", by Alan Oscroft