You may not realize it, but you don't have to have a lot of money to invest a lot of money. It's possible to invest "on margin," by borrowing money from your broker. Many people have done so, and many people have regretted it.
See what super investor Warren Buffett thinks about investing with borrowed money -- he addressed it in his latest annual letter to shareholders:
Investors, of course, can, by their own behavior, make stock ownership highly risky. And many do. Active trading, attempts to "time" market movements, inadequate diversification, the payment of high and unnecessary fees to managers and advisors, and the use of borrowed money can destroy the decent returns that a life-long owner of equities would otherwise enjoy. Indeed, borrowed money has no place in the investor's tool kit: Anything can happen anytime in markets. And no advisor, economist, or TV commentator -- and definitely not Charlie [Munger] nor I -- can tell you when chaos will occur. Market forecasters will fill your ear but will never fill your wallet.
Margin, in a nutshell
First of all, know that we're not talking about profit margins here, such as gross margin, operating margin, or net margin. Instead, we're talking about buying stocks "on margin," where you borrow money with which to invest from your brokerage. Of course, your brokerage isn't permitting this out of the goodness of its heart. Instead, it charges you for the privilege.
The interest rates brokerages charge often vary depending on how much you borrow. At one major brokerage, the recent rates were 6.25% if you borrowed a million dollars or more, and 9% if you borrowed less than $10,000, with a handful of rates in between, for different ranges of borrowed sums. At the same time, a different brokerage charged less than 1.75% for borrowing anywhere from a dollar to a million dollars -- and even less for greater sums. (The lesson? Clearly -- shop around!)
How much you can borrow? Up to 50% of the price of the securities you buy. So with a brokerage account that qualifies as a margin account (which involves having at least $2,000 in it and filling out an application), if you hold $100,000 of assets in it, you can borrow up to $100,000, and your total buying power is $200,000. The equity in your account is the collateral that you're putting up for the loan. If the value of your investments start falling significantly, you can expect a "margin call" from your broker, asking you to sell some assets to generate cash, or to deposit more cash into your account. If you fail to do so, the brokerage may just sell some of your holdings for you.
Interestingly, the 50% limit hasn't always been in place. Investors could borrow much more than that decades ago, which is one of the reasons so many investors were wiped out after the 1929 stock market crash.
Why use margin?
The appeal of margin is this: leverage. If you only have $40,000 with which to invest and you borrow $20,000, suddenly you have $60,000! Clearly, if things go your way, you can make a lot more money in stocks with $60,000 than with $40,000. Imagine, in an extreme example, that you earn a 50% return on your money in a year. Without margin, you'd increase your $40,000 to $60,000. But using margin (and ignoring interest costs for the sake of simplicity here), you can see your $60,000 become $90,000. Pay back the $20,000 you owe, and presto -- you made a profit of $30,000 instead of just $20,000. See why it's tempting? Of course, few people earn a 50% return in a single year. But whatever your gain is, it will be amplified if you use margin.
Why run away from margin?
Remember, though, that when you use margin, your losses are amplified, too. Losses are not uncommon, either. Many investments head south for short or long whiles, because of poor investment choices, bad luck, or the tanking of the overall market.
Let's use another simplified example. Imagine that you have $40,000 and borrow $20,000, and over the course of a year, your investments drop by 50%. If you hadn't used margin, you would have lost $20,000 from your initial $40,000, leaving you with $20,000. If you borrowed $20,000, though, you'd still owe $20,000. So you'd end up with $0. You would have lost everything when your investments only fell by half. (And again, we're ignoring interest costs, which would have added to your losses.)
If you invest on margin, you can lose more than you invested. If you borrow a lot for a long period, you'll accumulate interest costs, which will increase your debt load, resulting in rising interest costs. It's not unlike how credit card debt grows, when it's not paid down. If you buy a lot of stocks on margin and the market enters a slump, you'll either have to pay off the loan by selling off fallen stocks or by adding more cash to your account, or you'll try to just wait out the downturn, which could take years, while interest charges mount.
Investing on margin can be tempting, but it's also risky. And, of course, it's worth keeping in mind that you can do well in the stock market without resorting to margin in the first place.
Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.