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Buying Stocks on Credit      

by Jim Stevens ([email protected])

BURLINGTON, VT (June 17, 1999) -- In the second step of the 13 Steps to Investing Foolishly, we learn how smart it is to get the out of credit card debt before we begin to build our investments. It's a top priority -- one of the first things we want every visitor to our site to read.

Woe to the investor who tries to build up an investment portfolio while simultaneously being soaked for 1% to 21% interest on his debts. You'd have to be making 16% to 21% after taxes just to break even! This kind of debt has got to go before an investor gets serious about long-term investing.

With that piece of advice written boldly in your rule book, I'd like to add this advice: set up your taxable brokerage accounts as margin accounts. A margin account is a brokerage account that lets you buy securities on credit, using the securities you buy or already own as collateral for the loan. Loan rates are much more attractive than evil credit card rates. Currently you can find rates from about 7% to 9%.

Gee, first we say get out of debt, and next we're getting primed for a new kind of loan -- what's the deal? Well, if for no other reason, get a margin account to avoid inconvenience when you are buying stocks.

Let's say you have $5,000 cash in your account and you want to invest the full amount in stocks. If you don't have a margin account, you have to take extra care to see that your buy orders (including commission) don't exceed $5,000. If they do, you'll have to scramble around and get the additional funds to your broker within three days. Some brokers won't even execute a trade without all cleared funds available, so you may end up having a trade cancelled.

On the other hand, if you are trading in a margin account, the trades just sail through and you can make up any small discrepancies at your leisure. Having a margin account costs nothing extra. The only cost is the interest on the borrowed funds. For many people this can be almost nothing if you use it just the margin to cover an occasional "overdraft" that you quickly make up.

Wading a bit deeper into the margin pool, the loans can also be used to "leverage" an investment portfolio. Margin can be a way to add some extra return to your portfolio if you think your investments will provide returns higher then the cost of borrowing. There's no free lunch, though. You are also increasing your risk.

Let's say you've got $40,000 to invest. If you buy $50,000 worth of stocks in your margin account, you'll have written yourself a loan for $10,000. Assume your broker's margin rate is 8%. $10,000 is 20% of $50,000, so you'd be considered 20% on margin. If the stocks go up an average 20% during the following year, the value of the stocks in the portfolio will be $60,000. After paying back the $10,000 borrowed plus the $800 in interest, your account would be worth $49,200. That's a 23% gain over your $40,000 original investment even though the stocks only went up 20%.

Of course, stocks don't always go up. In that case, your losses will be equally accelerated in the wrong direction.

By federal securities law, brokers can let you go out on margin up to 50%. This means that the loan can be as high as 50% of the total value of the cash and equities in your account. This is definitely a scary prospect. If you are margined to the hilt, a significant drop in the value of your portfolio could trigger a call from your broker to pony up more money or sell some of your securities: the dreaded "margin call." This might have you selling your stocks at the worst possible time.

Use a conservative level of margin -- say, 20% -- and the danger is drastically reduced. At most brokerages, it would take a drop in stock value of about 71% to flag a margin call. That kind of drop in a well-chosen group of 10 to 20 stocks is nearly unprecedented (but, of course, not impossible).

Margin is a nice way to get incrementally more aggressive in a strategy you are already comfortable with. Check my Keystone Leverage report to see what this kind of "conservative" level of margin could have done for a hypothetical Keystone 10 portfolio since 1986.

Used Foolishly, margin can be a powerful implement in the Workshop tool kit.