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Written by Value Seeker
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Thursday, 17 July 2008 |
For many investors, utilizing margin to buy more stock can be tempting. Brokers generally have very good margin rates. Some will let you borrow at about fed funds + 1-2% if your margin balance is sufficiently high. While borrowing on margin can have its benefits, this form of leverage needs to be utilized carefully.
For starters, always remember that to make money on leverage, your return must beat the amount you pay in interest. So when interest rates are high, it is very difficult to make money while borrowing on margin. Also, if the amount you borrow is relatively low and you use a standard broker, the margin rate may be as high as 11-15%. This is almost impossible to beat unless you are Warren Buffet, so it is best to just avoid margin altogether.
If borrowing on margin does make sense for you, always leave yourself plenty of breathing room to avoid a margin call. Even if you think you found an amazing stock at a super cheap price, that stock could keep going down. In the short run, the market is highly unpredictable and variable. Even if it is totally clear a stock is undervalued, selling may ensue for whatever reason.
The last thing you want to do is leave yourself in a precarious situation where you are forced to start selling stocks at firesale prices. This can happen though if you overleverage and find yourself in a margin call. Even worse, your broker reserves the right to sell stocks on your behalf, meaning he will be selling your stocks to cover the call. Don’t expect to get the best price when your broker starts selling your shares willy nilly at market.
In short, even if borrowing on margin makes sense for you, always beware of the risks of overleveraging. Not only are you taking on more risk by borrowing money to buy stock, you are also taking on the risk of a margin call if your bet goes against you. Remember, even if you end up being right in the long term, in the short term, the market can still swing against you. If you are overleveraged, you may find yourself having to sell most of your position, only to find out a year later that you were right about the stock and wish you could have held those shares.
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