By John Drachman
After building up a portfolio that brings an investor newfound affluence, it’s only natural that thoughts turn to playing the market a little and “having some fun.” Like doubling down on a blackjack hand, buying stocks on margin gives an investor a powerful way to leverage a portfolio’s value by borrowing money to invest in more securities.
On the face of it, buying stock on margin is like buying a house with a mortgage. If the house goes up in value, you stand to make a healthy profit from an investment that was about 90% leveraged at the time of purchase. With the wrong market conditions, of course, both houses and stocks can lose a lot of value quickly.
When is it appropriate then for an investor to buy stocks on margin? Here are a few “Do’s and Don’ts” to guide your decision on whether to swing for the stock market fences or hunker down.
- Realize buying on margin is highly speculative. If things go south, a heavily margined portfolio can get downright scary and turn the sleepiest blue chip portfolio into an out-of-control roller coaster. Fueled by unmet margin calls, the legendary Crash of 1929 catapulted the nation into the Great Depression. More recently, investors who bought shares of GT Advanced Technologies on margin for their retirement accounts saw their savings evaporate after the firm went bankrupt in 2016.
- Prepare for the unexpected. Margin maintenance requirements differ by institution. Firms reserve the right to change their requirements at any time too. That means you could potentially face an immediate demand to pay off your margin debt balance with no warning.
- Understand margin’s full-spectrum risk exposures. In the wrong market environment, the fall-out for missed margin calls can mean plummeting credit scores, soaring insurance premiums, restricted bank borrowing capacity and demands from utility and phone companies for cash security deposits.
- Consider using a cash account instead. If you’re not ready for margin, think about funding a cash account for the purpose of making opportunistic stock purchases – and skip the borrowing.
- Don’t buy more shares than you can afford. No matter what else transpires in an account, margin investors are on the hook for repaying their debt. That’s why all account assets, as well as an investor’s personal guarantee, are held as assurance that payment will be made immediately. Monitoring your margin account closely will be critical to staying within the speculative allocation boundaries you staked out.
- Avoid margin investing without professional validation. Let’s face it: chasing performance can get emotional. Buying on margin upends diversification strategies too. A professional advisor can offer both a cool head and objective insights when needed most – before you over-leverage your portfolio.
If you are at a point of your life when you have the resources to succeed or lose big through more speculative investments, margin offers a near instantaneous way to up your portfolio’s ante. At the same time, sharing your thinking with an investment professional can help you stay aligned with your personal risk and reward profile. With some professional validation, you can engage in shoot-for-the-moon strategies like buying on margin – with assets allocated for just that purpose – while ensuring the rest of your portfolio doesn’t plummet back to earth.
John Drachman is a contributing writer to www.myperfectfinancialadvisor.com, the premier matchmaker between investors and advisors. John is an IABC award-winning writer, who applies his 30 years of financial marketing experience toward advancing the dialog between investors and investment professionals.