Mr. Cheap Answers – Should I Buy Some Stock on Margin?

by Mr. Cheap

We recently received the following question by e-mail:
Hi Mr. Cheap, I just wanted to get your opinion on this theory and if you think its worthwhile in the long run. The theory goes like this; for every dollar you have in a trading in account, you can borrow a dollar on top of that. In some accounts, even more than that. Now, I’m a young guy(21) and plan on investing in dividend stock that offer me a decent yield(over 5%). I have an account with scottrade and the most they will charge you on inteest in a given year is 7.5%.
My question is, if I started off with $2,000 in account and therefore have buying power of $4,000(due to the 1 for every 1 rule), would it be better to buy $2,000 worth of  shares as I can of a stock like MO(altria) using only my cash which gives me a 7.5% dividend or $4,000 worth of shares? The idea behind this question is that in the first year, the money I make on the extra shares earned on the first year would be canceled out with the interest paid to scottrade for the borrowed money but every year after that, my extra shares earned off the borrowed money would be able to compound interest free. Another note is that as time goes along after my initial deposit of $2,000 into my account, I would continue to put in about $200/month and hopefully more as I earn more. This would allow me to buy more shares and therefore earn more more interest on the shares as time went along. Does this make sense? After the first year, am I right that I would be making pure profit off the extra shares that I earned from the borrowed money?

To start with, I’m not 100% sure what changes after the first year.  If you borrowed $2000 and bought stock with them, and if the dividend payments EXACTLY matched the interest payments, you’d keep paying on the debt forever (not just 1 year).  If you mean that you’d be paying off the margin debt with $200 added to the account each month, yes you’re right (I guess you’d pay it off in about 10 months ignoring dividends from the stock you bought that wasn’t on margin and decreased interest payments as you paid down the debt each month).  I wrote a post about doing something similar to this.

I always enjoy question / discussion about buying on margin (or with other borrowed funds). I share you sense of excitement when considering constructing such financial vehicles, as it almost has the feeling of playing alchemist, creating wealth out of nothing. Please be aware that this feeling is *FALSE*, and there’s nothing magical about buying on margin. Basically you’re exchanging increased risk for increased reward (as they say, there’s no free lunch).

To begin with, Altria is a great company and a great dividend payer. At it’s current dividend yield of 7.36% you’re right that its dividends almost match the interest you’d be paying, and it *looks* like you’d be owning the stock for free. That’s how I felt when I bought Bank of America (BAC) on Feb 4th, 2008 for $44.46. At that point it had a dividend yield of 5.8% and had been increasing its dividend for 30 consecutive years (read over the analysis and look some more at the company’s recent history since this was posted if you want to be impressed by Dividend Growth Investor and his analysis).

To make the analogy perfectly clear, Altria may be a great company but you never know what the future holds. I was shocked that BAC cut their dividend. I was floored when Washington Mutual went bankrupt. The future isn’t certain, and nothing makes it impossible for Altria to cut its dividend or go bankrupt (perhaps Obama might decide everyone in America has to stop smoking since Michelle made him quit).

If Altria cut its dividend a number of things would happen:

  • Your dividend payments would no long cover your interest payments and you’d have to make up the difference yourself
  • The value of the stock you own would probably plummet, meaning that you’d owe more money than the stock you used it to purchase is worth
  • If the stock price dropped enough, you’d get hit with a margin call, which would force you to repay a portion of the money you owe, otherwise they’d sell stock (at a loss) from your portfolio to cover it.  We regularly get people complaining on our brokerage posts about having been forced to sell at a loss due to a margin call.

One of the other considerations is that borrowing to invest is great from a tax perspective, but as a young guy, your income probably isn’t in the highest bracket, so you won’t be able to benefit from this (as much as a 50 year old medical doctor might for example).  I’ve been backing off on my margin debt for partially this reason:  I’m a poor grad student, so the tax deductions don’t help me.

I know I shouldn’t make investment recommendations, but I can’t help myself.  Personally (and remember, I’m just some guy who likes to blog) I’d suggest you save up cash in a high-interest savings account (and keep adding the $200 / month to it).  As a 21 year old, who knows what the future holds and you may find capital preservation most valuable at this stage in your life (you could use that money to start a business, deal with a financial emergency, as a down payment on a condo or house, to pursue further eduction, to get married without going into debt, etc, etc, etc).

If you *insist* on getting the cash into the stock market, I’d follow Canadian Capitalist‘s sleepy-mini portfolio (or one of the other easy, passive investment vehicles).

If you *insist* on buying an individual company, and understand that you’re massively increasing your risk & volatility by doing so, I’d buy MO (or whatever company you decide on) in a low fee brokerage account (Scottrade is pretty good at $7 / trade) WITHOUT using margin.

If you *insist* on buying on margin, I’d suggest you consider a strategy I mentioned at the start on using margin to lower trading costs and keep the margin debt below 10% of your portfolio value.  When I was 58% on margin, the Canadian Capitalist wisely assessed this feelings on this as “Ouch. What are you thinking Mr. C?” (read over the comments on that post, a lot of smart people there recommend approaching investing on margin VERY cautiously).

Do any commenters have additional / alternative suggestions for a 21 year old thinking about getting into margin investing?

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{ 6 comments… read them below or add one }

1 Four Pillars

I don’t think Scottrade is available to Canadians. Zecco and TradeKing are cheaper than Scottrade for Americans. Questrade at $4.95 is the best deal for Canadians.

And yes – margin/leveraged investing/SM/Smith Manoever is no free lunch.

2 Four Pillars

I just noticed that in the email he mentioned having an account at Scottrade – sorry I didn’t see that before.

3 Nurseb911

Margin? I have an investment LOC that I prefer to use over margin (although this is the same principle of borrowing to invest). I wrote a piece on leveraging dividends earlier in the year and its still a path that I follow for my dividend growth portfolio. As long as you have the cashflow (dividends + savings) to meet your interest payment and repay some of the principal each month then I think its a good strategy for a conservative investor. If you’re stretching yourself too thin and picking the wrong type of stocks in proportion to each other then I think you can find yourself in a lot of trouble as we say with margin calls last year.

4 Jess

At 21, I invested in Real Estate first and start a home business. Starting with RE and Home Based Business gives me an education and experience you will not get from school. For example I gain education and experience in looking at Financial Statements, cash flow management, sales, marketing, and etc… By gaining at these, I’m able to invest properly when it comes to stocks, mutual funds and etc… I can read their financial statements. I have a feel of where the trends are. Right now, I’m educating myself about Derivatives and how to create them.

5 Canadian Capitalist

I avoid margin entirely. The equity-risk premium may not be much more than the premium that margin accounts charge over the risk-free rate. Why even bother?

6 Dividend Growth Investor

Wow, I hope I impress at least someone with my posts ;-)

I don’t use margin either. Earlier this decade I played around with S&P 500 futures and lost a lot of money in the process ( well not a lot, but it felt like it). Basically the main idea behind S&P 500 e-mini futures is that for a low downpayment of $4K-5K ( margin) you could control a vehicle that’s worth $50K ( assuming S&P 500 is trading at 1000). Thus for each “point” that the S&P 500 moves you make/lose $50. I thought I could make 2 points/day, but at the end it ended up more like losing $100/day ;-(

As far as dividend stock investing is concerned I would not rely on any particular stock too much. I try to be diversified, dollar cost averaged, reinvesting dividends selectively and not to overpay for stocks. I also own a long term bond(zero coupon, purchased when interest rates were a little higher) which would mature in a few decades that would provide me with return of capital of my principle invested in a few decades.

I also hate paying commissions. There are several US brokers which have virtually free stock trades ( provided that you maintain a minimum balance there).

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