Investing with margin, or borrowed money, might seem like a good way to boost your returns. But it's important for investors to realize that it's not that simple. Using margin dramatically increases your risk. In this Nov. 17 Fool Live video clip, Fool.com contributors Matt Frankel, CFP, and Jason Hall discuss how investing with margin works and why it's so important for new investors to know exactly what they're getting into.
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Jason Hall: Let's talk a little bit about what margin is. I just had this article pulled up. Did I already lose it? Here we go, found it. I'm going to share a link. I really did, I lost it. No, here it is. I got a link from our good friend, Chuck Saletta, one of our fellow contributors, to an article he wrote that talks about margin, options, and other practices. Here's how he describes investing on margin. When you're investing on margin, you're essentially borrowing money from your broker to buy securities that leverages your potential returns both for the good and for the bad. Think about leverage. When you think about investing in companies, we always talk about their balance sheet, we talk about debt. We talk about debt, we refer to it as leverage. It's a way to leverage capital that they can reinvest in the business to grow the business, whatever they do. We talk about banks, we talk about leverage. They're taking cash as deposits, the deposits are a liability on their balance sheet because they have to give people back their money that they have in deposits, but the cash is the asset. They lend out like 90 percent of that cash, so they're highly leveraged. When you take on margin, you're doing the same thing; you're creating an enormous amount of leverage. Now, the risk, in a way, it's like the risk with a short, because if you short a stock and the price goes up, it affects you because you're getting squeezed because it's doing the opposite of what you want, you're losing money on the way up. With margin, your risk is you used margin, you borrow somebody else's money to buy stock. Let's say you want to buy $2,000 worth of stock. You want to spend 1,000 of your own cash and you're going to borrow 1,000 from your broker, so you buy $2,000 worth of stock. Now, let's say something happens in that there's a market crash. The stock falls 30, 40 percent. Let's say they announced bad earnings and the market drops 25 or 30 percent. At some point, it's going to get to a point where the collateral that you have promised to cover that loan is going to be not enough to cover the value of the loan. That's when you can have a margin call, and that's when your broker literally calls in whatever you have promised to cover whatever that loan is. What that means is they reach in and they take it away from you to cover that loan. Unless you cough up cash or send money directly to them to cover it, they can actually takeaway assets that you have used to satisfy the guarantees for that loan. So there is a huge risk there, because short-term uncontrollable things can take that margin and create enormous losses just very, very quickly. The positive side is that when used appropriately without creating large risk of that leverage is that it can really induce returns. It can. Because if you buy a stock and let's say, again, you pay half in cash and you borrow half in margin, and the stock goes great and goes up substantially, well, guess what? You get to sell that stock that you borrowed for $1,000. Let's say it's tripled in price, you sell it for 3,000. You pay back 1,000, you just profited $2,000 just like that, it came out of nowhere. That's how it can be really powerful. But obviously again, there's enormous risks. Matt?
Matt Frankel: It's also the dangerous part that can sucker people in.
Jason Hall: That's entirely that.
Matt Frankel: The thought of these big returns out of nowhere, out of stock that they didn't even really have the money to buy. When people go to open a brokerage account and they're asked if they want a cash account or a margin account, which one should they choose?
Jason Hall: If they don't really know exactly what it means, they should absolutely not choose a margin account. The bottom line is that if you choose margin account and you really don't know what you're doing, you could end up buying stocks on margin not even completely realize that it happened.