Don’t Use Margin to Invest
On your path to becoming a better investor, you must not use margin. This is a very very big rule and we are coming to you with lots of experience on this. Don’t ever use margin to buy stock that you can’t pay for with cash.
If you don’t know what margin is, it is borrowing money from your broker to invest in stock or some other security. For example, you could have $10,000 in your account and, with margin, buy $20,000 worth of stock. Also, for those that have asked, you can have a margin account without having to use margin debt.
Don’t get tempted by leveraged returns. If you think you are smarter than the market and can double your money much easier, you are wrong. What will likely happen is that the leverage you use in your margin account will leverage you on the downside and accelerate your losses.
Here’s an example of what happened to a friend of ours:
It was January 2000 and the stock market had been soaring for over 10 years. Our friend had a great year in stocks and had worked his portfolio up to $500,000. Because of all the gains he had to pay taxes of over $75,000 that year. Since his stocks were doing so well and hadn’t hit his goals yet, he decided to pay his taxes from margin and then sell his stock in a few months to cover the loan. In essence, he owned $500,000 of stock but owed $75,000, making his account worth $425,000. Then March 2000 came and stocks plummeted.
His technology stocks lost 20%, 30%, 40%, 50%, 60%, 70%, 80% and even 90% of their value over the next few months. When the value of his stocks kept dropping, the margin amount increased from the original 15% to over 80% of the value. He had to sell his positions just to keep the margin calls from stopping. When it was all said and done, his stocks declined by more than the margin was worth and he lost everything! Everything! He lost all of his investments and he didn’t have the savings to buy into the stocks that had been so beaten down. Over the next few years those stocks climbed by hundreds of percents and he wasn’t able to capitalize on them. Using margin wiped out his account.
This is an extreme example, but you should realize that investors are often tempted by margin because they are overly optimistic or feel like they can’t be wrong. In our experience, these are the two most common times that stocks fall, when investors and analysts and economists don’t expect them to. If you ever use margin make sure that it is never to make a big bet. Even if you think it is low risk you just don’t know what will happen.
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