Buying on margin is basically buying stocks with money borrowed from your online broker or brokerage firm. The rewards are magnified and far outweigh the risk because it is a leveraged transaction (leverage is the use of borrowed money to make an investment and the return on an investment). Leverage allows people to get more done with the same amount of resources and your potential for profit is greater because you are doubling your money to purchase stocks versus purchasing the stocks outright. It challenges the old adage “It takes lots of money to make money.” Additionally, margin investing allows investors to essentially double their buying power by using their existing funds and stocks they own as collateral, and then borrowing against those assets at a reduced interest rate to purchase stocks.
Regardless of method, tactics or philosophy used by individual investors, all forms of investment in the stock market involve some risk. Therefore, investors must look at risk versus reward when making their investment decisions. The three most mentioned risks associated with margin investing follow. First, investors could lose more than what they paid for the stocks. Secondly, investors do not have sole control over their stocks. Finally, investors must be prepared to deposit more assets in their margin account on short notice if their stocks experience a significant decline. All the aforementioned risks are easily avoided by monitoring your portfolio and selling any marginally performing stock that drops 10% in value. Now, lets look at the many rewards associated with margin investing to determine if its worth the risk. First, Investors can typically buy more stocks (double their money) than not obtaining a margin loan. Secondly, they can increase their rates of return on assets invested e.g. if the investor’s stock pays a dividend, the dividend amounts are deposited into the investor’s brokerage account. Thirdly, brokerages typically transfer investor funds they hold to a money market account, which pays a higher rate of interest than your typical bank saving account. Finally, Investors can repay the loans at anytime without penalty, can use these loans for purposes other than buying stocks, and can use their margin accounts for other security transactions e.g. short sales, bond purchase, and options trading. As you can see, the rewards far outweigh the risks and this type of investing just make good sense for the savvy (well-informed) investor and for the beginner who is willing to learn about margin investing.
Even if margin investing sounds too risky for you, you may want to open a margin account. There are two reasons why. First, margin loans have a lower interest rate than other loans because they are secured with investments that your broker holds. Again, the loans can be used for purposes beyond buying stocks. This means that if you need money for something, you can get it without selling investments (something that would have tax consequences) by merely writing a check on your brokerage account.
In today’s financial markets, with many stocks of outstanding and well managed companies trading at all times lows, buying on margin to double your buying power makes even more sense. Consequently, more investors are buying securities (stocks, bonds etc.) on margin than ever before. Canadians have had an average of $10 billion in margin borrowings during 2000, and Americans have quadrupled that amount, which is nearly four times the level of a decade ago.