Using Margin to Lower Trading Costs

A great way to invest is to make regular investments.  Million Dollar Journey recently outlined 4 ways to invest small amounts of money each month, all of which are solid and worth considering.  I agree with his 1% rule (the trading commission should never exceed 1% of the value of the trade), which can make it difficult to execute trades even with low cost brokers for people starting out with investing.

One idea to get around this is to use margin.  Let’s assume that we are using a brokerage that charges $4.95 / trade and that we have $150 / month to invest.  Let’s also assume that we’re aware of the risks of buying on margin and we want to keep our account, at most, at 10% on margin (a margin call occurs when your account exceeds 70% on margin). To keep things simple, we’ll ignore changes in stock value, dividends, interest (paid or collected) and brokerage fees.

Using the 1% rule, as long as we buy at least $495 of stock we’ll keep our transactions costs at or below 1%.  After 4 months we’ll have saved $600 and can make our first purchase.

Now say, instead, that after THREE months we transfer over the $450 to our brokerage account, then buy $495 worth of stock (perhaps a nice, highly-diversified ETF).  This would put us $45 on margin, or 10% (45/450) of our account.

Next month we transfer $45 to pay off the margin loan, then start accumulating money to buy again. After we have $405 we can afford another purchase (since we can now go up to $90 on margin and stay under our 10% rules).

Eventually (in this scenario in the 3rd year of investing) we’ll get to the point where we can just keep paying off the margin debt, and every time it is paid off, purchase 10% more of our portfolio worth.  This lets us put money into our portfolio every month at no cost, slowly lowers our transaction costs as a percentage of purchase (since 10% of the portfolio SHOULD be an ever increasing amount) and take advantage of dollar cost averaging.  We own the stock we want sooner, and can get a tax deduction for the interest paid on the margin debt (and avoid paying a higher tax rate on the interest we would have earned if we saved up to make purchases in a high-interest savings account).

There is also the added benefit that if we ever can’t make our monthly payment, it’s not a big deal (since the margin debt will always be conservative compared to the size of the portfolio).  Conversely, if we have a windfall, it can be immediately applied to wipe out the  margin debt (or add to the portfolio and increase the margin amount).

The dangers of this approach are quite slim, as our portfolio would have to drop by over 80% before we were in any danger of a margin call (which would be unlikely to happen in a month or two unless we were investing in VERY volatile equities).

I don’t do this and I don’t necessarily advocated others do it, but if people want to minimize their fees, while being able to add small, regular amounts to a stock portfolio I think this would be a reasonable way to do so.  Another approach is Mike’s ETF vs. Index Fund strategy (which involves simple, regular investments in index funds until a set amount is reached, depending on fees and MERs, at which point the funds are sold and ETFs are bought with the proceeds – very similar to MDJ’s idea #4).

Do you make monthly contributions to an investment account?  How do you do so to minimize fees?