Buying on Margin

Q: I am a relatively new investor to stocks, with previous experience only in mutual funds. Since I have little to invest right now, I have acquired a line of credit through which I plan to make stock purchases on margin. Is this Foolish? -- P.L., from the Internet

A: To get the definition section of our answer out of the way, "margin" investing involves borrowing money from your broker in order to make more purchases in your brokerage account. "I have margined my account 25 percent" translates to "I have borrowed against 25 percent of the value of my account to purchase more stocks."

Now that we've finished with the definition, let's quickly outline our response: "Yikes!"

We certainly applaud and celebrate every investor's move away from the underperforming world of actively managed mutual funds and into the more interesting and rewarding world of picking his or her own stocks. However, we would urge newer stock investors to wait five years before thinking about experimenting with the risky world of margin investing.

The danger with margin is that when something goes wrong, time is not on the side of the margined investor. For instance, in 1996 one of the model portfolios on The Motley Fool held America Online. Due to a temporary little problem with the company (i.e., everybody who tried to use AOL was just getting busy signals), the stock lost nearly two-thirds of its value over a period of two months. Investors who held on during those dark days have since been richly rewarded, as the stock quickly rebounded, and today is worth nearly 30 times what it went for during the busy signal era.

Some who had bought AOL on margin, however, weren't so fortunate. When the stock dropped more than 60 percent, those who were too heavily margined received the dreaded "margin call" from their broker. When an investor is on margin, and the value of the stocks in his account plummets to the point that he has borrowed more than the (usually) allowable 50 percent of the worth of his holdings, an investor will either have to sell off part of his stock to pay back the broker or put new money into the account. Thus, many margined investors (despite having picked what would prove to be one of the best stocks ever) had to sell off some of their holdings of AOL at exactly the wrong time in order to meet the margin call.

For these reasons, and others, we urge extreme caution with margin. Better to simply invest what you have, determine your tolerance for risk in the market, and spend five enjoyable years learning, before having to sweat every drop (and there always are some) in your portfolio.

WHAT NOW?: The Fool's Rule Breaker Portfolio still holds AOL and is now up more than 1,000 percent on the stock over the last 4 1/2 years. To watch how a portfolio can make those kinds of gains without ever using margin, check out www.fool.com/portfolios/RuleBreaker/RuleBreaker.htm.