What Do Rising Interest Rates Mean for You?
Can you borrow money to buy stock? From a bank, no. But there are alternate ways to obtain funds for investing in stocks.
You may hear from time to time that banks do not loan money for stock trading. That may be, but it doesn’t mean you can’t borrow money to invest in the stock market.
Once you get enough experience and education, your friends and family may want you to invest their money to help their financial situation. They may just loan you money to help you get ahead. But you probably don’t want to be responsible for Grandma’s retirement funds. Luckily, there are other options.
Like the real estate market, the stock market allows ample opportunity to use Other People’s Money (OPM). As a stock investor, you can take advantage of something called a margin account.
Buying stock on margin allows you to leverage your money in a way that’s little different from how a real estate investor would use a bank loan.
Rich Dad philosophy is to use debt once you have become educated, not before.
But once your do, leveraging money with good debt is something that should be respected rather than something that should be feared. The debt that people should fear is debt that must be paid off by working at a job.
What Is a Margin Account?
Buying on margin is borrowing money from a broker to purchase stock. Instead of getting a loan from your bank, you are getting a loan from your broker. Leveraging margins allows you to buy more stock than you’d be able to normally. This allows you to make more money and trade in greater volume. However, this also allows you to lose more money for the same reasons.
Remember, debt is not to be used lightly. It demands great respect and education.
To trade on margin, you need a margin account with your broker and you need collateral. Collateral is usually in the form of existing stocks you’ve already purchased. As with just about any loan, these are not free. Your broker will charge an interest rate. If you are buying stocks for the long term, make sure the gains will cover the cost of extended interest rates.
Once the account is opened and operational, you can borrow up to 50% of the purchase price of a stock.
Why use margin? The same reason real estate investors use debt: leverage. Leverage amplifies every point that a stock goes up. If you pick the right investment, margin can dramatically increase your profit. Pick the wrong one and it can dramatically increase your losses too.
The Dangers of Buying on Margin
Just like the clinking sound and flashing lights in a casino, buying stocks on margin is one of those things that might seem to be a way to make money fast.
A broker might tell you, “Once you have a few thousand dollars in your brokerage account, you might qualify to borrow money against your existing stocks at a low interest rate to buy for even more returns!”
The problem with buying on margins, is that is entirely speculative. It’s a strategy that can transform the “safest” blue chip into the riskiest.
It’s like the gambler at the poker table that goes “all in” on a pair of twos before the flop. He’s assuming that the flop holds another pair of twos. Foolish and short-sighted.
There are countless numbers of examples of traders who purchased stock on margin, only to wake up the next morning having lost it all.
Leverage is the fastest way to build wealth, but it is also the most dangerous. We often say debt is a lot like a loaded gun. If you use it without training and education, terrible things can happen. If you use it correctly and with your education, it can be a great tool.
Margin Trading Is So Risky It’s Regulated
Margin trading is considered so risky it’s regulated by rules set by the Federal Reserve Board, self-regulatory organizations like the NYSE, and FINRA (Financial Industry Regulatory Authority), and brokerage firms.
Earlier this year, margin debt hit record highs in what some have deemed “The year of the margin.”
The Wall Street Journal reported:
Margin debt has been on the rise for years and is generally considered a gauge of investor confidence. The long-running stock rally has helped push debt levels higher since investors tend to be more willing to take loans against investments that are rising in value. However, it can also precipitate a steep market downturn as it did before the burst of the dot-com bubble and the financial crisis of 2008.
The growing loan balances have caught the attention of Wall Street’s watchdog, FINRA. In January, it published an investor alert after the total value of margin loans broke $600 billion for the first time, saying investors may be underestimating the risks of trading on margin and may not understand how margin calls work.
Just to put it into perspective:
- The current debt is greater by 50% than the debt in 2007.
- Double the amount of margin debt borrowed at the peak of the Tech Bubble
- It’s equal to the entire economy of Taiwan.
If the bubble bursts as I’ve predicted, disaster is inevitable.
This is not child’s play. Trading on margin is not a set-it and forget-it strategy.
I’ll say it again; margin trading is only for the educated. But there are some common-sense strategies that you can use to mitigate inherent risks of margin trading.
1. Avoid being leveraged to the max. Just because your brokerage says you have the ability to borrow X amount of money, doesn’t mean you should. Leave yourself some breathing room in case your trades go against you.
2. Use margin only for short-term trading. Like I said earlier, it’s not a buy-hold strategy. The interest can add up fast and over a long-term period it can be substantial. It’s best used for short-term, opportunistic trading where you need leverage.
3. Get educated. Closely monitor your investments and stay on top of market developments that may affect them. Be aware of release dates for economic data that can move the markets.
Even if you have all of your bases covered you must understand margin trading is best left to sophisticated—and educated—investors, and high-net investors who are conversant with risks. You can be that, with some work.
The uneducated investor is best to invest in his 401(k).
Editor, Rich Dad Poor Dad Daily