Don't Buy Stocks on Margin Even If the Interest Rate Is Low
Double Taxes on Dividends and Bankruptcy Risk Are Just Some Pitfalls
I cannot tell you how many times I encounter new investors who talk about buying stocks on margin, especially given how inexpensive interest rates have been in recent years. Don't fall for it! In fact, let me be blunt to the point that it risks offending you: Outside of a few situations in which highly experienced, financially secure investors take advantage of it for limited times under limited circumstances, if you buy stocks on margin, you're probably being an idiot. You can lose money and you will deserve to lose that money. Walk away.
That might sound harsh but I need you to fully understand the additional risks you introduce when you deploy even a small amount of margin debt in your portfolio.
When You Buy Stocks on Margin, Your Broker Can Call the Loan at Any Time
There is sometimes this mistaken idea that if you pay your balances, you have a certain percentage of equity, or you stick to certain stocks, the lender won't harm you by suddenly, if not irrationally, calling the whole thing due at the worst possible moment. It's wishful thinking. Your broker can and will call your margin debt whenever, and however, it wants. You are not entitled to a phone call or the opportunity to make an equity deposit to pay off the balance. You have no protection. There is nothing you can do about it because you agreed to it when you applied for margin privileges in the first place.
Maybe it doesn't like something a representative saw in your credit profile. Perhaps it is in financial trouble and wants to shore up its own balance sheet, unable or unwilling to lend. Maybe it is run by prudent men and women who think the market is severely overvalued and who don't want to create a credit risk for the equity owners of the brokerage firm itself. There need not be rhyme nor reason, instant repayment is always on the table whether you like it or not.
When You Buy Stocks on Margin, You Can Find Yourself In Bankruptcy Court
Margin debt balances are real debt; every bit as real as going to the bank and signing on the bottom line for a mortgage, swiping a credit card, or taking out a student loan. Due to the ease with which new margin loans can be created under ordinary circumstances, investors sometimes fail to treat these liabilities with the respect they deserve. This means you should always have the cash to pay the entire worst-case-scenario balance in full; immediately available, sitting in the bank. This isn't a suggestion, it's a commandment. Transgress at your own demise.
There are ordinarily three reasons you'll be glad if you follow this policy with religious-like conviction.
First: Companies go bankrupt or experience permanent capital impairment from time to time. . An excellent illustration comes from a firm called GT Advanced Technologies, which I once examined on my blog. Many "investors" not only put irresponsible percentages of their capital in the business thinking they were going to get rich from owning it, but they piled on the danger by acquiring call options and purchasing common stock on margin. One of the worst cases I saw was a poster who lost $750,000 on the stock and $140,000 on options tied to the stock. By the time it all washed out, he had a negative margin debt balance of $107,000 he owed to his brokerage firm. It took out 15 years of his hard-earned savings and left him a hole that is going to require either a large check or an appeal to mercy at the bankruptcy court. It's a tragedy.
Second: Market panics, displacements, volatility, and shocks can, do, have, and will occur. There have been times in American history when the most incredible businesses have traded near, at, or below the amount of cash it has in the bank due to the need of stockholders to dump their ownership as quickly as they can to raise whatever money possible so they don't lose their house, their farm, or their other property. Almost nobody saw 1973-1974 coming. Few saw 1929-1933 coming. It doesn't matter that Coke is really worth more than $40 a share in intrinsic value to a reasonable long-term investor, it could have a market value of $10 tomorrow. You have to have both the resources and legal ability to retain ownership during these dark moments (which, if you are prudent enough and have a lot of surplus cash and cash flow, can be incredible once-in-a-generation opportunities to get exponentially richer). As one famous economist quipped, "Markets can stay irrational longer than you can stay solvent". This is especially true if the leveraging effect of margin debt works against you.
That leveraging effect can be powerful. It isn't out of the ordinary for the stock market to fluctuate by at least 33% every few years. Even a modicum of margin debt can turn that into a margin call. And don't think you'll have a chance to sell on the way down, either. It's a beginner's mistake to think that for a stock to go from $100 per share to $20 a share, it had to hit $99-$21 along the way. That's not how it works. It's a real-time auction; as the experts constantly have to remind novices, the price can immediately move from Point A to Point B without ever hitting anywhere between the two. Alternatively, the stock market can close entirely so you can't raise liquidity even if needed. In other words, you may not have the opportunity to sell securities to pay the margin debt. You'll have to cover it all from your own pocket by wiring it from a local bank to the broker on demand.
3. When You Buy Stock on Margin, You Can Pay Higher Taxes on Your Dividend Income
Imagine you buy $100,000 worth of Royal Dutch Shell shares on margin. You should collect around $6,500 per annum in dividend income at the present dividend rate per share. Had you bought the stock outright, those dividends would have eventually been counted as "qualified dividends", which means you'd pay significantly lower tax rates, typically ranging from 0% to 23.8% (inclusive of the Affordable Healthcare Act surcharge for high-income earners) at the Federal level. Instead, there's a good chance your broker is going to take the stock in your account and lend it out to short sellers - you'll never know about it or even notice - pocketing additional income for itself. When the dividend is paid on the stock, you don't, technically, own it even though it looks like you do in the brokerage account. Instead, you are given a "payment in lieu of dividends" equal to the dividends you should have received.
The problem? Those payments in lieu of dividends are taxed at your ordinary income tax rate, which can be nearly twice as high! For bigger portfolio balances, this starts to represent real money.
4. When You Buy Stock on Margin, You Can Trigger Massive Capital Gains on Certain Types of Holdings
Master limited partnerships are complex publicly traded securities that have unique tax characteristics and are not appropriate for most investors. Though it is far beyond the scope of the discussion in this article, suffice it to say that if you buy MLP interests through a margin brokerage account (as opposed to a cash brokerage account with no margin capability), under a series of circumstances entirely out of your control, your broker could inadvertently trigger a situation where the IRS deems your position sold, causing you massive capital gains taxes despite not selling anything. Having to come up with a lot of money for the government when you haven't liquidated a position can severely reduce your returns as you lose the deferred tax advantage.
When It's Alright to Utilize Margin Debt in Your Brokerage Account
Personally, I think the margin balance of an account should never exceed 5% of the market value and even then, only be tapped for short-term cash flow needs (e.g., you are depositing additional funds in a few days but want to make a purchase today). A better alternative, in my opinion, is a negotiated line of credit with your local bank; a line of credit you can tap at your own discretion. Another option is to segregate your U.S. Treasury bill holdings into their own margin-authorized account, keeping your stocks, MLPs, etc., in the non-margin account, and tap, perhaps, as much as 30% of the market value of the Treasury reserves.There's still a risk, but all things considered, it is relatively mitigated.