Margin Can Make you Rich…or Really Really Poor

What if you could double your returns on a 5% increase in stock price with no extra work? Sounds good right? That is the sales pitch you often hear from some stock brokers when they try to convince the average investor to buy stocks using margin – or borrowed money to purchase investments. When things go well, margin has the wonderful impact of multiplying your gains sometimes to the tune of doubling your returns. However, what brokerage houses don’t tell you is that when things go bad they also can double your losses and take you to the dark side.

Take a look at this chart that was published in an April edition of the Investor’s Business Digest (Insert aff link). In this chart, the first column highlights various returns an investor could see on a stock holding. The second column shows what your return would be if you do not use margin and use only the money you have to buy the stock. The third column shows what your return is if you use margin to buy that stock.

Click to Enlarge

Everything looks awesome when the shares price rises. However, have a look at what happens when the stock you hold starts to turn to the dark side. If your stock tanks by -15% and you are loaded up on margin, then your actual return on the stock will be -30%. Essentially you have lost that 30% in stock value but you also have to pay back that money you borrowed to buy the stock with. When one of my holdings drops by 30% I feel dumb enough as it is (thanks Citigroup) – I don’t need to feel like a full-on dumba$$ by doubling that loss because essentially I made a bet on the stock price going up.

As long term dividend investors, margin is probably something that I would suggest we stay away from. Perhaps it has a place, but I honestly can’t think of one. Let me know if you have used margin and how it worked out for you using the comments section.