Margin is debt. You borrow capital from your broker to buy more assets, in most cases stocks.
This gives you leverage. You are making a bet that your returns on the investments you buy on margin are going to be greater than the interest rate you pay your broker for the privilege, net of commissions.
If they are, you pocket the difference. If not, than you have to make your broker whole.
Since the broker uses the assets you already own in your account as a collateral to satisfy your margin, investing on a margin is very similar to buying a house on mortgage.
The only difference being that when you invest, you do not have to make monthly margin payments and the broker is generally not too worried if you ever make any effort to reduce your margin as long as there is sufficient value in your investments to cover for it.
The similarity does not end here. Taking on a mortgage to buy a house can be good, or bad. It depends a lot on who, how, why, and the level of financial savvy of the borrower. Investing on margin is the same way.
If you understand how it works, use it judiciously, and can manage your risk well, it can help you generate nicer returns. On the other hand, if you are not disciplined enough, or misuse it or get carried away chasing a hot stock, it can drain your account dry.
When to Not Use Margin?
In this case I think it makes better sense to eliminate the situations where margin should not be used, before we talk about the situations where it makes sense to use it. Sure, there are always exceptions, but these principles hold true for most common investing scenarios.
Principle #1: Do not use margin to buy interest bearing assets that yield lower than your margin interest
Yes, you can buy bonds of all varieties, treasuries and many other assets that throw out reliable yield. Most of the time, because of the perceived safety of these instruments, the brokers will allow you to lever up more than 1x, which means that $1 of your collateral might allow you to buy $3 of municipal bonds (as an example). Theoretically, if the yield on this muni is more than 1/3rd of the interest rate on your margin, you could possibly make a few basis points of supposedly “risk free” income. The problem arises if the interest rates move and the slim window of profit can quickly flip into a cash flow drain. Besides, anything that complicates your investing so much for returns so small is not worth doing.
Principle #2: Do not use margin to buy stock in a utility company, REIT, MLP or other type of Trusts
Similar principle as above. Any stock that is mostly used to generate a current income in form of dividends is not a candidate to buy using margin. In most cases, the yield will be lower than your interest rate, and capital appreciation may not be enough to make up for it. If you are buying stocks for income, you are likely a conservative investor and margin just adds more risk that you should not carry. Dividend investing is not a bad thing; just not recommended on margin.
Principle #3: Do not use margin to make a down payment on a car, boat, or a house
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Just because you can borrow money from your broker to make a down payment does not mean you should do it. In this case, you are borrowing money which will become a basis for more debt (car loan, mortgage, etc). If you have to do it, that means you are not financially strong enough to buy or invest in these assets. Multiple levels of leverage is financial insanity and can come back to bite you much sooner than you think.
But using margin is not all bad, if you know how.
When and How to Use Margin?
Too much debt kills, but a little debt can go a long way towards giving you financial flexibility. However, it is important to use margin as a tool only when you have a good investment that you are not able to get in otherwise. Let’s take a few examples
Example #1: A great investment opportunity arises and you are temporarily short of capital
It often happens that your next contribution to your investment account is a few days or perhaps a week away, and it can easily cover the amount you are going to invest in this opportunity. Assuming this is not a hot tip stock, and you have satisfied yourself of the merit of the investment, go ahead and use margin to start your position. In a few days you will send in more cash and your margin will be covered.
Example #2: Using margin as an emergency fund
If you have a need for cash that cannot wait – for example, an unexpectedly large tax bill, where the consequences of not paying full taxes on time are greater than the interest on the margin, it is okay to go ahead and borrow on margin. In many cases you may need time to figure out which investments to sell to cover the margin, or perhaps you can do it over time with your income.
Example #3: Year end tax planning
Let’s say you have a few investments you want to sell so you can redeploy capital in other more attractive investments. If your current investments have significant capital gains, you may want to wait for the new year to sell them so as to not incur additional taxes in the current year. However, due to traditional tax selling by investors and funds, many investments become quite attractive towards the year end, which you may want to take advantage of. A proper use of margin will allow you to bridge the temporary capital gap.
For a disciplined investor, margin should always be used in moderation and only when necessary. When possible, try not to use more than 10% of your asset value as margin and draw a line at 30%. It is also a great idea to use brokers like Scottrade that have cheap margin interest rates. Remember, the margin interest compounds as long as you keep the margin open.
About the Author: Shailesh Kumar writes about stocks and value investing at Value Stock Guide, where he offers individual stock picks and ideas to registered members. Subscribe to his free stock newsletter for investment ideas that you can use to research further.