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.

---

Moving Average Convergence Divergence ( MACD ) Charts

The Moving Average Convergence Divergence charts, or MACD charts for... Read More

Short Selling for Investors

Shorts. Let's see. If there are shorts there must be... Read More

Getting Started In Investing

Are you ready to open your pathway to financial independence?Well... Read More

The Basics of Tax-Free UK Financial Spread Betting

Financial Spread Betting (or Trading) offers a tax free method... Read More

High Volatility Investments

Penny stocks and options are high volatility investments that attract... Read More

Find a Methodology and Minimize Investment Madness

There are many reasons to be investing these days, and... Read More

How to Use Annual Report

There are many steps in calculating the fair value of... Read More

Help with My Annuity

The cries are heard from the distance, "I need help... Read More

The Conflict of Interest Game

Disgruntled investors are going after Wall Street once again, this... Read More

The Differences Betweeen the Wealthy and Everyone Else

I recently received an e-mail from a young lady who... Read More

Boost Your Income With Financial Spread Betting

About 6 years ago I started to notice that certain... Read More

Just what is Arbitrage Investment?

In the simplest of terms, Arbitrage means to exploit price... Read More

The Perfect Economy?

The U.S. economic data reported this week showed strong output... Read More

July 2005: Hurricane Forecasts for Weather Traders

Tropical Storm Arlene formed as a tropical depression on June... Read More

Volatile Range

The stock market fell sharply Thu and Fri before and... Read More

Before You Invest You Must Read This

It is important to answer the following questions before you... Read More

Planning for Retirement

Almost without exception, people don't start planning for their retirement... Read More

Issuing Warrants to Investors

When raising capital for a business venture, warrants are a... Read More

Shareholders Meeting Changing With Times

A significant number of corporations that settled accounts in the... Read More

Who Wants To Be A Millionaire?

I am sure you have probably read about the power... Read More

An Old Dividend Stock Investment Idea, for a New Generation

Death and taxes! The certainties of life! And then, of... Read More

June 2005: Weather Forecasts for Weather Traders

If Johannes Kepler, the renowned 17th century astronomer and discoverer... Read More

What is an Investor Ready Business Plan

A Business Plan, as all good entrepreneurs starting out in... Read More

Franchise Opportunity Sellers Beware; franchise buyers lie on forms?

It seems completely absurd that franchise buyers lie about their... Read More

Success Trading: More Basic Terminology for New Traders

One important aspect of trading the markets is to understand... Read More