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The Online Advisor - April 2000
Look carefully before you invest on margin
As the bull market surges forward, more and more Americans are investing in individual stocks -- not just mutual funds and certificates of deposit. As people look for additional ways to participate in the market's phenomenal growth, the use of margin loans is becoming more popular.
What is a margin loan? It's similar to a home equity line of credit. With an equity line of credit, you pledge the equity in your home as collateral, and the bank lends you funds based on that collateral. With a margin loan, the collateral is your securities -- stocks, bonds, or mutual fund shares, for example.
Here's how it might work. Let's say you invest $10,000 in cash and borrow another $10,000 on your margin account to buy stock worth $20,000. If the stock rises to $22,000 and you sell it, you would repay the margin loan and have a profit of $2,000 on your $10,000 investment (20%). If you hadn't taken out the margin loan and, instead, paid $20,000 in cash for the stock, your gain of $2,000 on that $20,000 investment would have been only 10%. (This example does not reflect interest on the loan, commissions, capital gains taxes, or other expenses.)
Of course, stocks can also fall in value. Let's say the value of the stock in the above example dropped to $18,000. Your equity in the stock would have fallen to $8,000 (market value minus the loan balance). This means the stock would have fallen 10% in value, but your loss would have been 20% ($2,000/$10,000). Borrowing to purchase the stock would have actually amplified your loss.
Margin loans are also subject to margin maintenance calls. Brokers generally require that you maintain a certain ratio (often 30 to 35%) between your equity and the outstanding balance in your margin account. If your stocks drop substantially, you may be required to add more cash to your account to keep the ratio in line. If you're going to buy on margin, it's a good idea to maintain a reserve of cash for possible margin calls.
Generally speaking, margin borrowing is for those
who can tolerate substantial risk, who hold a solid and diversified portfolio, and who have reserves they can draw
upon to cover margin calls.
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