"Margin can you make you rich..."
Like the sirens' song, margin calls out to investors with an appetite for risk. Its lure has ruined many, yet its skill at printing money in bull markets is often tough to resist. However tempting margin may sound, prudent investors should avoid it at all costs.
Image source: Getty Images.
Here's the big problem with trading on margin: What will you do when your stocks fall?
The ins and outs of margin trading
Straight from TD AMERITRADE's (AMTD +0.00%) Margin Handbook, a margin-enabled account offers investors a way to make money from borrowed money:
[B]ased upon Regulation T of the Securities Exchange Act of 1934, which is currently 50%, you can double the amount you invest in qualified securities as long as you maintain the minimum value in your account and conduct all trades within your margin account. As an example, if you were buying $10,000 worth of marginable securities, you could make the purchase using $5,000 of your money and $5,000 of your brokerage firm's money. Investors who buy on margin pay interest on the loan portion of their purchase (in this example, $5,000), but normally do not have to repay the loan itself until the stock is sold. After repaying the margin loan, any profit or loss belongs to the individual investor.
It doesn't sound too bad, right? At least not until you understand the cost of margin. Your hard-earned equity is now your broker's collateral; and they will protect their collateral -- even if they have to take control of your portfolio to make it happen.
When you trade on margin, you become a slave to the unpredictable whims of the market, paying interest while you're at it.
The Margin Handbook continues:
Since the value of the marginable securities in your account serves as collateral for the loan, margin accounts require that your equity meet or exceed certain minimum levels. If it should drop too low, your brokerage firm will ask you to increase the value of your account by trading assets held in your portfolio, such as selling securities, buying to cover short positions, or closing options positions. Or you may deposit marginable securities or cash into the account.
How would you like your broker to tell you to sell your favorite stock when you're sure its plummeting price is not reflective of its intrinsic value? In fact, you would prefer to buy more shares as prices fell, but instead you were forced to sell shares at a loss to meet your broker's equity requirements. That's no fun. And that's probably exactly what happened to many Apple investors over the past 10 months.
The Apple problem
As Fool contributor Evan Niu recently pointed out, Apple's underperformance combined with the sheer volume of clients trading the stock on margin has weighed on TD AMERITRADE's margin balance.
During TD's most recent earnings conference call, "[CEO Fred] Tomczyk acknowledged that this is very much related to Apple, as the Mac maker is one of the most popular investments among margin investors," Evan explained.
For the most part, the company's metrics echo a resurgence of confidence among its clients as the market touches new highs. But this isn't the case when it comes to the company's margin balance, a very important interest-earning asset for brokers.
Source: Data retrieved from 10-Q filings for respective quarters shown.
TD AMERITRADE's Apple problem highlights what I feel is one of the biggest problems with trading on margin. I can imagine some of these investors who really believed in Apple might have wished to add to their position as Apple stock fell. In fact, maybe they wish they could buy shares today; Apple stock is still down 35% from its September 2012 high of $705. But thanks to a leveraged account, many investors who would have preferred to buy more shares were likely left with no buying power -- or even worse, were forced to sell Apple shares at irrational lows.
Where's Rick Guerin?
Have you ever wondered what happened to Warren Buffett and Charlie Munger's third partner, Rick Guerin? Or maybe he's so long gone that you've never even heard his name? Leverage had its way with him. As value investor Mohnish Pabrai told the Motley Fool in an interview, Buffett told him that "Rick was just as smart as us, but he was in a hurry." Levered with margin loans, Rick's ambition was his downfall.
What does Warren Buffett think about margin? The two lessons Pabrai took away from his lunch with Buffett both seemed to directly defy margin trading:
- Avoid leverage.
- Be patient.
Too bad Guerin didn't understand these important principles. Forced to sell his class-A Berkshire Hathaway shares at a fire-sale price of less than $40 due to a margin call, he sold the very stocks he probably desired to load up on.
And who was there in the 1973 and '74 downturn to buy Guerin's undervalued Berkshire stock? None other than Warren Buffett himself. Free of leverage, he had cash on hand to load up on the shares he thought were a good deal.
Patience wins in the end
Margin kills. Margin prevents investors from having cash when it's most useful. Don't invest on margin. Instead, be patient. In doing so, you'll empower yourself to buy when everyone else is selling.
I can't think of any better motivation to avoid margin's tempting lure than the advice Buffett shared with Pabrai: "If you're even a slightly above-average investor who spends less than they earn, over a lifetime you cannot help but get rich if you are patient."
