Living beyond your means is a big enough danger to your finances. But a less visible practice -- investing beyond your means -- can be even more destructive.
Investing with "margin" -- money borrowed from your broker -- offers the tempting possibility of turbocharged returns. But one wrong move could leave your portfolio devastated. One Fool community member lost more than $60,000 with it. My colleague Toby Shute has also detailed the margin-al adventures of Chesapeake Energy (NYSE:CHK) CEO Aubrey McClendon. Whether you're an everyday investor in your 20s or the head of a major corporation, margin can come back to bite you.
Running numbers
To see more clearly how margin can cost you a fortune, simply look at the margin interest rates some brokers charge. Schwab (NASDAQ:SCHW) recently imposed between 6% (if your debit balance was $2.5 million or more) and 8.5% (if it was less than $25,000). At TD AMERITRADE (NASDAQ:AMTD), the rates were between 6.25% (for debit balances of $1 million or more) and 9% (for less than $10,000). Keep in mind that these rates apply at a time when interest rates are near record lows!
Think about what those rates really mean. If you're borrowing money at 8% or 9%, you'd better be certain you'll earn more than that -- not only to cover the cost of the loan and deliver profits, but also to reward you for the risk you've taken on. The market has averaged 10% per year over the very long haul, but over many relatively lengthy periods, it has averaged much less. Even a promising company such as Coca-Cola (NYSE:KO) has averaged just 1% a year over the past decade. If you'd invested in it on margin, you'd have been paying a lot in interest while waiting in vain for the stock to appreciate.
Imagine paying 8% or 9% interest over a few years while invested in the following companies, all of which have earned five-star ratings from our Motley Fool CAPS community:
|
Company |
CAPS Rating (out of 5) |
5-Year Avg. Annual Return |
|---|---|---|
|
CEMEX (NYSE:CX) |
***** |
(11%) |
|
Coventry Health Care (NYSE:CVH) |
***** |
(9.9%) |
|
Honda Motor (NYSE:HMC) |
***** |
7.1% |
|
PepsiCo |
***** |
4.1% |
|
SYSCO |
***** |
(2.1%) |
Data: Motley Fool CAPS.
Sure, you would have seen your investment in Honda beat the market (the S&P 500 ended pretty much where it started over this period). But even Honda's 7.1% annual gain might not have been enough to cover the interest you'd have been paying in margin.
If you're thinking of making millions by using margin, think again.
