It would be hard to find a podcast-hosting duo more totally invested in answering your financial questions than Alison Southwick and Robert Brokamp -- they put "Answers" in the show's name, for goodness' sake! And this week, they're at it again, combing through the Motley Fool Answers mailbag in search of conundrums to address for their listeners. But because three heads are better than two, for this episode, they've enlisted the help of Sean Gates, a financial planner with Motley Fool Wealth Management.
In this segment, we have a case of a man trying to balance two conflicting Foolish dictums. Isaac wanted to take advantage of February's correction to snag some undervalued stocks, but to do so, he had to buy on margin. It worked out -- this time -- but what he really wants to know is: Was he being Foolish, or just foolish?
Sean Gates is an employee of Motley Fool Wealth Management, a separate, sister company of The Motley Fool, LLC. The views of Sean Gates and Motley Fool Wealth Management are not the views of The Motley Fool, LLC and should not be taken as such.
A full transcript follows the video.
This video was recorded on June 26, 2018.
Alison Southwick: Next question comes from Isaac. "In the first week of February, the market took a hit. I read several articles about why it happened and really couldn't pinpoint a good reason. I believed the sell-off was irrational, so I took $3,000 out on margin and decided to only hold for one month. My thought process was that I could buy solid companies that had reported good earnings or were about to. However, I did not want to hold for long because I know that margin can be dangerous.
"So, I bought five companies. At the end of the month, I sold everything for a total gain of just under 10%. I know it's a small amount of money, but anything helps a medical student. This strategy seemed to have worked well for me, despite making the poor decisions of using margin and holding for a short time period. So, my question: was this foolish, Foolish, or somewhere in between?"
Robert Brokamp: I love how Isaac's doing this while he's in medical school. [laughs]
Southwick: Got some time on your hands, Isaac?
Brokamp: Yeah, exactly, in between gross anatomy.
Sean Gates: I would say the answer falls, squarely, for me, on somewhere in between.
Southwick: [laughs] This is decisively somewhere in the gray area!
Gates: I mean, it's foolish from the standpoint of, you're sort of convincing yourself that this was a good decision because you thought you had some sort of insight into the irrational sell-off in the market, but you really don't have any insight into what no one knows.
Brokamp: Nobody does.
Gates: Yeah. And, also, the timeline. The timeline was very short. That's foolish, because you should only be risking that type of equity with money you're willing to lose, essentially, on a 50-50 coin flip. I don't know that you were, in that case. Maybe.
But, I think one of the positive things of this question that's Foolish is, margin isn't always bad. I think margin gets a very bad rap. It's almost like it's a risk zone that no one should go into. But it's just a form of debt, in a way, and everyone uses debt to facilitate their financial goals. I personally used margin to finance some of my own house. Houses here are ridiculously expensive and I didn't have a $200,000 down payment, but I did have an investment account.
I think one of the things to take away is, it's important to have a taxable account that you can use for margin. You need a fairly large taxable account because margin has requirements. Let's say, for example, you have a $100,000 taxable brokerage investment account. You wouldn't want to take $70,000 on margin, because now you're at a 70% margin loan balance, and that's very risky. If the stocks go down, the margin requirements will get called and they'll just sell everything on you. But, if you took out $20,000 on a $100,000 account, now you have a 20% margin balance, and that's not so bad. It's very unlikely that stocks are going to drop 80% and have to have you force-sell positions. So, yeah, I would say that's a Foolish way to utilize margin.
Brokamp: Basically, margin allows you to magnify gains, but has the potential to magnify losses. As long as you're willing to do that, it's OK for some people. But, I would say, definitely, investing in the stock market for a one-month timeframe because you feel like you have a specific insight into that, that's pretty risky.
Gates: The other interesting thing is, he says his total gain is 10%. I'm wondering if he included the margin interest cost in that calculation. Probably not. There is a cost associated with doing margin loans.
Southwick: Yeah. I assume you have short-term capital gains and all that, too. No?
Brokamp: You would, yeah.
Gates: Yeah, it depends. There's a raw cost to borrow. If you have a 4% interest rate on your mortgage, there's a raw cost interest rate to lend out that money. But then, there are other implications. If you have to sell to pay down the mortgage, you would have short-term and long-term capital. There's a ton of knock-on effects.
Brokamp: And you can't use margin in an IRA. If you're using margin, they are going to be tax consequences.