THE RISKS OF BUYING ON MARGIN
Written By: Angelie Vivekanand
October 23, 2023
While the technique of “buying on margin” is becoming increasingly accessible and can potentially mean higher returns, it should be used with caution as it can also lead to large losses very quickly.
Do-It-Yourself Investing
Do-it-yourself (DIY) investing is a style of investing where you as the investor get to build your own investment portfolio. This means that you can decide what stocks, bonds, ETFs, mutual funds, etc., to invest in without any formal advice. There are many platforms that have emerged which help to facilitate DIY investing including Wealthsimple, Questrade and BMO Investorline. This style of investing is good for investors who are knowledgeable about investing and are comfortable having control of their own investment decisions.
What is Buying on Margin?
As a part of DIY investing, there is one investing technique available called ‘buying on margin.’ Buying on margin refers to borrowing money from a broker to purchase investment products such as stock. In order to borrow this money, you must offer up other personal investments as security for this loan. This means that if you cannot pay the loaned amount back to the brokerage, they have the right to sell some or all of your investments as payment for this shortcoming.
In order to buy on margin, an investor needs to open a margin account. Within this margin account, there is a minimum dollar amount (called the maintenance margin) that must be kept in the account at any given time. The amount borrowed from the broker does not count towards this maintenance margin – only an investor’s own equity counts towards this minimum.
For example, Aalia invests $3,000 of her own money in Stock X through her margin account. Aalia buys on margin and therefore borrows $2,000 from her broker, which brings her total amount invested in Stock X to $5,000. However, only the $3,000 she personally contributed counts towards the maintenance margin in her margin account.
Advantages of Buying on Margin
The benefit of buying on margin is that it enhances a given investors’ buying power – you are able to buy more shares than you would normally be able to afford. For example, using the same example as above, Aalia is only able to afford contributing $3,000 of her own money to investing in Stock X. However, by buying on margin and borrowing $2,000 from her broker, she is now able to invest a total of $5,000 in Stock X, as opposed to just $3,000.
Disadvantages of Buying on Margin
Forced Margin Calls
When the amount in an investor’s margin account drops below the maintenance margin (as a result of, for example, a fall in the share price), the broker is likely to issue a margin call. A margin call forces you to either add more funds to their margin account or to sell some or all of their investments in this account in order to bring the amount back up to the maintenance margin.
This is where the risk lies. If you add more funds to their margin account, and share price continues to fall, you will lose more money. If you sell the existing shares in their account, you are locking in the loss that you’ve already experienced. Either way, the investor is likely to incur a loss.
However, the even bigger issue lies in the fact that you are still on the hook to pay your broker back the amount that you borrowed. No matter whether you see gains or losses on your investment, you still have to pay your broker back.
Losing More Than Initially Invested
With traditional investing, an investor will only lose the amount that they initially invest. However, when buying on margin, you can lose more than you initially invested because you are also required to pay back the amount that you borrowed from the broker. In the event that this loan amount is not paid back, the other personal investments that you put up to secure this loan will be seized. Therefore, while there may be advantages to buying on margin, the risks involved make this style of investing not suitable for everyone.
Gains are Stumped by Interest Rates
The amount that an investor borrows from their broker, like any loan, is subject to interest payments. Therefore, not only are you on the hook to repay the loan amount, but you are also required to pay interest payments to your broker. The longer an investment is held on margin, the more interest charges that will be incurred and the higher the likelihood that the interest charges will outweigh any gains made on this investment.
Additionally, interest rates can go up at any time. Therefore, it may cost you a lot more than you initially thought to pay back what you borrowed from your broker.
Think Twice
It is crucial that investors consider all of the above factors and the underlying risks associated with this investing technique before making the investment decision to buy on margin.
Disclaimer: This information does not, and is not intended to, constitute legal advice. This document is for general informational purposes only and may not constitute the most up-to-date information. The links to other third-party websites are only for the convenience of the reader and we do not endorse the contents of the third-party sites.