For those of you unfamiliar with buyingsecurities on margin through afull-service broker, listen up. Let's sayyou have good reason to believe that acertain stock is undervalued and is likelyto increase in value in the nearfuture. Or you think, based on carefulanalysis, that the current freshening inthe market is more than that, and isperhaps a return to bull market status.You want to get in on this potentialgain but don't think you have enoughmoney to take advantage of what youthink is a star-crossed situation.
You could reallocate your currentholdings (ie, sell something else) or putyour monthly savings into your hunch.Not good enough, you think, palms gettingmoist. This is where your friendlybroker steps up and asks, "Why not buyon margin?" The brokerage firm willloan you the money you want, currentlyup to 50% of the collateral that is yourinvested account with them, and you'reon your way to a magnified, leveragedgain using someone else's money. Whatcould be better than that?
After all, margin investing is up onWall Street 25% so far this year. Isn't thisthe way some of the big boys have gottenrich? You've been hammered 3 yearsin a row and this is your big chance to"get healthy," as they say in Vegas, andget your investment plan back on track.
Could be. But isn't there always acatch? Turns out there are 3. First of all,you have to pay interest, albeit at a modestrate, and it is possibly deductible.Secondly, what if, in spite of all youranalysis, your pet stock or the wholemarket inexplicably doesn't go up, or,horror of horrors, it actually goes down?These things cycle back, don't they?
Maybe. But timing is the issue, and ifyours is lousy, you'll find that the brokeragehouses and the feds who regulatethem have no patience or understanding.They have a collective memory backto the margin-accelerated Crash of '29and will be rigid in enforcing the fineprint of the margin agreement that yousigned in haste anticipating those bigreturns. This means the dreaded "margincall," which is a euphemistic way of sayingput more outside money into youraccount to restore the 50% collateral or,without notification or your advice, brokerswill begin to sell off possibly all ofyour holdings. Even worse, they have theright to change this percentage withoutnoticeâ€”probably not in your favor.
Losses Beyond Principal
The possibility of losing even morethan you invested is a worse outcomethan a lost lottery bet where you canlose only what you bet. Remember, too,the brokerage can still come after youfor the accrued interest and any remainingdifference on the loss owed to them.Although they would much rather youmake money on your account, theymake out either way with the incomefrom the interest and the extra transactionfees on your pumped-up account.They'll get you coming or going.
As usual, a big, quick upside potentialgain is balanced with the possibility of adownside loss. So the prevailing wisdomfor the average investor is "don't eventhink about it." But if you just can't resistthis 1 time, use some mad money that'sbeen set aside for you to play with.Remember, unlike a simple gamble, youcan lose more than 100%. Whadda deal.
Jeff Brown, MD, CPE, a partneron the Stanford Graduate Schoolof Business Alumni ConsultingTeam, teaches in the StanfordSchool of Medicine Family PracticeProgram. He welcomes questionsor comments at firstname.lastname@example.org.