What is Going on Margin?

There are some days that I think “man, the AI revolution is here. Next year, computers will take over.” Then I see Google’s AI recommendations like putting glue in pizza to make it better, eating rocks, and that James Buchanan graduated from UW in 2013. Yes, the AI revolution is here, but I think we have a few more years until computers dominate the earth.

Going on margin means using assets in your brokerage account as collateral to borrow money. Usually, investors go on margin to make additional investments that have a short time horizon like commodities options or short stocks. Investors (usually) don’t take a margin loan to purchase “buy and hold” stocks since the interest on the margin loan would ruin the gains.

To use a margin loan, the Federal Reserve mandates the buyer fund a minimum of 50% of the purchase. The buyer can use a margin loan for the remaining half. So why would you do this?

We’ve mentioned the term “leverage” before when talking about paying off debt, and leverage is the name of the game for margin loans (or any loans for that matter). Leverage utilizes OPM (Other People’s Money) to maximize your return on investment (ROI). Schwab’s explanation on Margin Loans breaks it down very well:

Without Margin Loan:

• You buy 100 shares of a $50 stock: -$5,000

• Stock rises to $70 and you sell all 100 shares: $7,000

• $2,000 Profit

• 40% ROI

With Margin Loan

• You buy 100 shares of a $50 stock: -$5,000

• You buy another 100 shares with a margin loan: $0

• Stock rises to $70 and you sell all 200 shares: $14,000

• You repay the Margin Loan: -$5,000

• You repay the interest (10%): -$500

• $3,500 Profit

• 70% ROI

So what are the downsides? Schwab’s website also breaks down losses very well:

Without Margin Loan:

• You buy 100 shares of a $50 stock: -$5,000

• Stock falls to $30 and you sell all 100 shares: $3,000

• $2,000 Loss

• -40% ROI

With Margin Loan

• You buy 100 shares of a $50 stock: -$5,000

• You buy another 100 shares with a margin loan: $0

• Stock falls to $30 and you sell all 200 shares: $6,000

• You repay the Margin Loan: -$5,000

• You repay the interest (10%): -$500

• $4,500 Loss

• -90% ROI

When using a margin loan, you are going to have bigger wins and harder losses. 

So maybe you’re thinking, well I just wouldn’t sell the stock until it went back up! The problem with that is the interest keeps building. If you hold the margin loan for too long, the interest payment might be more than your profit! The other problem is if the stock keeps going down you might suffer a Margin Call.

When using a margin loan, your debt to equity ratio must remain above the maintenance requirement which is usually 30%. This means the value of your margined assets must be at least 30% the value of the loan. Using the examples above, at the start, you bought $5,000 with your money and $5,000 with the loan. Your debt to equity ratio is 50%.

When the price per share drops from $50 to $30 and your overall stock value goes down to $6,000, your equity drops to $1,000 since the loan is fixed at $5,000. Your new debt to equity ratio is 17% ($1,000 in equity on $6,000 of stock). This is far below the maintenance requirement and the broker is going to do a Margin Call. You will either have to deposit cash to your account to bring your total value up or sell stock to lower your total debt. 

A margin call forces you to sell at a loss or add more money to secure the loan. All the while, interest is adding up. 

Lastly, not all securities are marginable. You could have $100,000 in your brokerage account, but if it’s all penny stocks and Yankee Candle ETFs you might not be able to use them for a margin loan if they are too volatile.

Margin loans are typically used by professional investors and big firms to make larger, short term bets without having to sell other assets. 

When buying my Yankee Candle ETF, I always see the detail “Marginable: No” on my Schwab account and have been curious what that means. Now I know. 

Now, just because you CAN do something doesn’t mean you should. I can do a lot of things with my money that I probably shouldn’t, like invest in rare fish.

Do you need to invest using margin to gain wealth? Absolutely not. We generally advise against touching margin in your primary investment portfolio at all. If you have the unquenchable urge to live life on the edge of disaster and you refuse to take no for an answer, take a small pile of fun money and use that to scratch the itch. If you’re living within your means and investing your money in ETFs/index funds and/or real estate, you don’t need to invest on margin to become financially independent.

*Please, please don’t use a margin loan to buy any cryptocurrency.

What We’re Reading/Listening To:

Podcast: Two Sides of FI - When is Enough, Enough? A lot of people have a hard time grasping the concept of “enough” when it comes to money. It can be easy to slip into the trap of working endlessly to ease your concerns of running out of money in retirement. That’s why it’s important to figure out how much money you need to retire once you get an understanding of your expenses.

Debrief on Deck

Next week, Mike is going to debrief May. Did April showers bring May flowers? Why did GameStop spike again? Why did Wilson try an instagram recipe when history has proven they never work? Stay tuned to find out.

As always, please reach out to us with any questions or comments you have. You can reply directly to this email or find us on social media (X (formerly Twitter) and Instagram).

Until then, stay the course.

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