Margin Benefits are Marginal at Best

Margin is one of those things that novices find puzzling about the stock market, but the concept is really quite simple. Still, with understanding the basics of using margin accounts, determining the wisdom of using margin can be quite a conundrum.

A margin account is a traditional investment account with margin privileges.

This means your broker has set up what amounts to a line of credit secured by the stocks and bonds in your account. Often this margin credit line is used to buy more stocks in the same account. But the account can also be borrowed against to buy real estate, make other kinds of investments, or simply to pay personal bills. The simple requirement is that enough assets must be kept in the account to maintain a certain value as collateral for the loan.

This is where trouble comes in. It's easy enough to maintain that collateral level when all is well, but when the economy becomes difficult and you are strapped for cash, this is also often the time when the market may drop. When the market drops temporarily, your equity value may fall, but the value of your debt doesn't change; you may encounter a "margin call" when you can least afford it.

A margin call is similar to any other loan being called in. You must pay up immediately. If you don't have the cash, your stocks and bonds are sold automatically to pay your debts. This compounds your problem: you end up selling your stocks when they are down, usually the worst possible time. Remember, the idea is to buy when prices are down and sell when they are up. So, in addition to all the other problems, margin loans can force you to make poor investment moves. In times of market crashes, a heavily margined account might be completely lost when the market drops only a fractional amount.

This leads to the idea of leverage, which is what margin accounts represent. Anytime you borrow to invest, you leverage your investment, or buying more than you can afford for a fractional down payment. Since one is buying stocks with borrowed money, or borrowing against stocks already owned, this is the result. Buying a home with a mortgage is a very similar process, but since the bank doesn't typically call your loan if home prices dip temporarily, many of the problems listed above do not arise. Still, a 95% mortgage is a highly leveraged deal, and it is very easy to lose your entire investment with even a small change in real estate prices. Even a typical 80% mortgage can wipe out the entire investment in a poor market.

Despite the many risks associated with margin or other forms of leverage, there definitely are advantages. Certainly, we've emphasized the opportunity to lose money faster, but you can also make money faster using these tools. If half of your equity comes from margin, you can gain money twice as fast. As stocks go up, your profits are compounded, because you own twice as many shares as you could normally afford. Thusly, when the market drops, you lose twice as fast.

Also, some people benefit simply by having a margin credit line available, without making use of it at all, or by only using it for short-term turnover. If used judiciously by a disciplined investor, there is virtually no risk in having access to a margin account. It is the use of the debt obligations that carry the costs. Imagine having a credit card that is never used, but the credit line is available in case of major emergencies.

In the end, leverage simply means that your gains or losses will be multiplied. Each investor must consider for him/herself the acceptable level of risk. However, we firmly believe that there are other risks, which carry better payoffs than simple use of leverage. While it is good for most investors to have access to margin, it may not be wise to use it often. In addition to interest costs, the added risks may end up causing more harm than good.

To send comments or to learn more about Scott Pearson's Investment Advisor Services, visit http://www.valueview.net

Scott Pearson is an investment advisor, writer, editor, instructor, and business leader. As President and Chief Investment Officer of Value View Financial Corp., he offers investment management services to a wide variety of clients. His own newsletter, Investor's Value View, is distributed worldwide and provides general money tips and investment advice to readers both internationally, and in the U.S.

---

Investing Pointers for Neophyte Investors

If you know next to nothing, how do you go about the business of investing? The first thing you need to know about investing is, how much... Read More

Day Trading Strategy or Stock Trading Software? The Way You Pick Stocks Affects Your Results

The trading method you employ to approach the stock market can make a big difference in your results.Stock trading is a very competitive field and in order... Read More

How to Calculate the Value of Your U.S. Savings Bonds

If you're like many Americans over the age of 55, you've probably had money taken out of your paychecks for years and years in order to purchase... Read More

Buy: Hold: Sell: Jump

I'm sitting here at my computer desk with a cup of coffee at my elbow. The coffee rest in a mug, the mug garnished with the words... Read More

Everybody Wants to Know How to Invest

Those unfamiliar with the process of making and managing investments often have more than a few trepidations about investing in general. They figure that, since they do... Read More

Commodities - The Next Big Wave of Fortune Building

Have you often wished you could have got in on a tremendous money making opportunity before it took off? How would you feel if you had bought... Read More

June 2005: Weather Forecasts for Weather Traders

If Johannes Kepler, the renowned 17th century astronomer and discoverer of the planetary laws of motion, could speak from the heavenlies, he might have a few words... Read More

An Economical Retirement Investment Plan

The practice of economy, directed toward a retirement investment plan in the stock market, is in itself a source of great revenue. It is the art of... Read More

Short Term Savings Products

When you invest, it simply means that you are putting your funds in products, in this case short-term savings vehicles, which will allow you to reap high... Read More

The American Age of Inflation is Over

"The American Age of Inflation is finished." So says economist Robert Samuelson in his December 2nd Washington Post column.This type of refrain is common. We often hear... Read More

Getting Started In Investing

Are you ready to open your pathway to financial independence?Well you should be. The sooner the better. But, how do you get started?There is so much to... Read More

Should You Put Your Annuity in an IRA?

Let me start by answering that question...if an annuity fits your investment objectives than there is no reason that an annuity should not go in your IRA.... Read More

How to Choose the Right Share Class

You'll want to opt for the no-load or institutional share class instead. If you're a no-load investor who is determined to buy a fund that's primarily broker-sold,... Read More

Stock Market Money Management Skills

Let's start by saying: You can't be afraid to take a loss. The investors that are the most successful in the stock market are the people who... Read More

Top Ten Investment Mistakes

1. Lacking an investment plan a/k/a/ "Don't take a trip without packing the map". A pre-planned asset allocation generates positive results and eliminates emotional panic selling.2. Buying... Read More

Critical Options Investing Tip When Trading Naked Calls and Puts

An option is a derivative trading product that is best used by investors as a hedging tool providing investing profit protection and profit enhancement. Although it is... Read More

How to Setup a Profitable Trading Business

In my opinion trading is the most exciting and best way to earn a living in the world. With just a small amount of equipment and space... Read More

Brain Snappers and Other Wall Street Nonsense

The last time you spoke with your broker did he use any of the following words? Diversification, Price-to-earnings ratios, discretionary trading, lifting a leg (he's talking to... Read More

Get Wealthy With the Rule of 72

When it comes time to retire how many people would like to have a nest egg that is 2 or 3 or even 4 times larger than... Read More

How To Find An Investment Advisor

Do you think you need an Investment Advisor? Hold on before you answer because this is sort of a trick question. Also, I am definitely biased because... Read More

Real Estate Clubs Hot Among Investors

Six or seven years ago, the stock market was booming, Internet companies that no one had ever heard of were valued at billions of dollars, and anyone... Read More

Why Do You Want to Become a Online Trader?

Motivational guru Tony Robbins teaches that the reason for doing something rates much higher than the methods you use to get the job done. In order to... Read More

Annuity Investment - The Whole Truth

Do you ever feel like you haven't been told the whole truth? Kind of like something is missing? Well, you are not alone.With many investors awestruck over... Read More

Types of Investment

The word 'investments' is one that most of us are familiar with hearing in financial context. For many of us, it may make us thing of big... Read More

Chinas Inscrutable Currency Strategy

Purpose: Expose Opportunities for Smart InvestorsThe move by China's central bank to drop the yuan's rigid peg to the dollar on the day of my return after... Read More

Investing As A Sport?

I said last week that money doesn't generally buy happiness, but the lack of it can buy absolute misery. This, by the way, is not just my... Read More