It may be tempting to buy stocks on margin as a way to magnify your returns, but doing so exposes your portfolio to extra risk, and can cost you thousands of dollars in interest on your brokerage account.
In this segment of Industry Focus: Financials, The Motley Fool's Gaby Lapera and Jordan Wathen respond to a listener's query about the pros and cons of investing on margin, and explain why margin is usually better avoided, particularly if your broker charges a high fee to leverage your portfolio.
A full transcript follows the video.
This podcast was recorded on March 20, 2017.
Gaby Lapera: "I have a question about trading on margin. I just opened a brokerage account and I'm building a portfolio of high-quality stocks that I intend to hold for the long-term. I'm wondering if there's a way to invest Foolishly using margin. For example, I'm making monthly contributions to my account and adding to my positions, keeping my transaction costs under 2%, but I don't always have cash on hand to make my purchases, so I end up using margin. Does it make sense to maintain a margin position as my portfolio grows? The interest rate is only 1%, and I'm hoping my returns will continue to exceed that hurdle. If I plan on holding my investments for the long term, the interest will be constantly adding to my margin position, and I will grow and grow at an accelerating rate over time."
First off, I did send this listener a set of articles about trading on margin, and I'm happy to send those to you if you write to firstname.lastname@example.org and ask for them. Jordan, I know that you and I have very similar risk-averse personalities. I'm going to say what I said to this guy, which is that I cannot give you personal advice -- I know I'm harping on this, but as always, I need you guys to know that. But, this is how I personally feel. I am a very risk-averse person, and trading on margin makes me very, very, very nervous. So, I would never personally trade on margin, but you have to decide what's best for you. What would you say, Jordan?
Jordan Wathen: I'm going to be a bit of a hypocrite, because I've short-sold things before, and that's inherently on margin, and exposes you to unlimited risk. But, truthfully, if you're going to manage a constantly long portfolio and you're going to use margin, it sounds like, to me, "Is it OK to use heroin one day a week, or every day of the week?" I'm never going to advise it, it's so dangerous. It looks so lucrative, especially when stocks are going up. If I just doubled my portfolio value by leveraging it, it would be fantastic, but ...
Lapera: Wait, actually, that reminds me: Can you explain what trading on margin is, real quick?
Wathen: Trading on margin is basically using the broker's borrowed money. You're borrowing money from a broker to buy stocks, and you pay interest on the margin. So, if you borrow $10,000 to buy stocks at a retail broker, they might charge you 4% interest on that every year, or $400 a year.
Lapera: Yeah. And that's great, as long as the stocks are going up, if you're not shorting. But the problem is, if you're shorting a stock in particular -- and that's when most people trade on margin, as opposed to our friend David -- there's potential for unlimited amounts of loss. I don't know if you remember this, Jordan, do you remember the guy who shorted KaloBios on margin?
Wathen: I did. It's a good lesson on why you should never short a biotech company.
Lapera: Yeah. This guy, what was it, a year ago?
Wathen: It was about a year ago.
Lapera: He shorted this company called KaloBios, and it was something like $3, and then it went up to $17 when he wasn't looking, and he lost an absurd amount of money. I think it was like $100,000. That's crazy. What he did was start a GoFundMe to help pay off a debt to his brokerage. Which is funny in and of itself. He's like, "I don't understand why the brokerage didn't tell me this could happen." They do. It's just in the fine print.
Wathen: Right. And that's a problem. They give you a 27-page contract. Everyone goes through it and signs their digital signature and then moves on with life. I can really categorize this into two basic ideas that say as a general rule, it's not good to use margin. The big one is that margin is not like a mortgage. If you go buy a house with a mortgage and the house drops 50%, the bank can't just show up, knock on the door, and say, "Hey, you owe us a ton of money." That's exactly how margin loans work, because it's mark-to-market every single day. If the stock you buy with margin goes down, you have to come up with money or you have to close it out. You might have to sell at a price you would never dream of selling a stock at, which is the No. 1 "oops, don't want to be part of that." The second one is, you're paying so much in general to borrow money from a broker that you're giving up a lot of the upside, but the downside is still 100% yours. If the stock moves against you, that's all your loss. If it moves up and that's gravy, you're still paying interest. You have a scenario where you get less than 100% of the upside, and 100% of the downside. It's not a great deal, conceptually.
Lapera: Yeah, definitely. There's a difference between shorting, which you do on margin, and investing on margin. I want to make that clear for listeners. But when a stock loses out, the most you can lose is 100% if you're trading normally. Like I said, if you're shorting, you can lose the way more than that. But if you're trading on margin, you're still on the hook for the amount of money that you borrowed, plus whatever you've lost in the stock itself. And I wanted to follow up on how that turned out for the listener who emailed me. And I know when we first talked about this, you were like, "Man, 1%, that's really cheap for trading on margin." But he wrote back after I responded and told me he had misread the fine print on the margin interest rate. He thought it was 1%, but it was actually 1% above the base rate of 8% percent. He says, "Needless to say that I won't be using margin going forward because I'm not confident in exceeding a 9% hurdle rate with my returns."
Wathen: Yeah, that's just massive. And truthfully, if you go to any retail broker, I don't think there's a single one even at $3 million of account equity that'll give you money at 1%. They just won't. Benchmark interest rates are 0.5%, why lend to Joe Blow on margin? You just don't. That's the thing. It's really hard to beat the benchmark at most retail brokers. And either way, it doesn't matter. Even if you didn't have to, I would just say, it's OK, just leave a little money off the table to not expose yourself to such massive losses.