When it comes to trading stocks, they can be bought and sold in two major account types known as cash and margin. Most of us are familiar with cash accounts as all IRAs are setup this way. However, with taxable accounts, margin can be employed to enhance returns. To better understand this, let's walk through these two important account types and work through a couple of examples.
Cash Accounts
The most basic way to trade stocks is in a cash account. In this type of account, cash is deposited and then trades may be placed using these funds. Stocks purchased in cash will deliver one-for-one returns based on their performance.
Margin Accounts
With taxable brokerage accounts, margin can be established. What this means is that a credit line is opened with securities held in the account as collateral. No interest is charged to the account owner(s) unless money is borrowed. Also, not all securities can be used as collateral. Well established stocks are fine, but thinly traded small companies or troubled large companies often are not marginable (meaning they cannot be borrowed against).
Risk and Reward Magnified
The reason many choose to use margin loans to purchase securities is to leverage holdings in an effort to magnify gains. However, just as gains are magnified, so too are losses. In addition, the risk trade off isn't exactly even because a margin loan also carries interest charges that vary based on prevailing interest rates. This is an important fact because the maximum gains are reduced by interest charges, while losses are deepened because of these costs.
Application: On the Way Up
During the latter part of the 1990s, technology stocks seemed to know no limits. As a result, many investors elected to use margin loans to leverage their portfolios and increase their returns. Interest rates were relatively low, and tech stocks were trouncing the overall market. The chart shows the tech heavy NASDAQ compared to the S&P 500. As you can see, investing in tech certainly paid with a gain of close to 80% versus the overall market at just shy of 20%.
Let's say an investor had a portfolio with $100,000 invested in the NASDAQ at the beginning of 1999. Using only cash, he or she would have gained approximately $80,000 (80%) in twelve short months. However, let's assume that he or she took out a margin loan for $50,000 at the beginning of the year to invest in the NASDAQ and that the loan had an interest rate of 8%. Over the course of the year, the investor would have gained $120,000 (120%) before interest charges and $116,000 (116%) after interest charges - a huge win for the investor. The portfolio would be worth $270,000 minus $54,000 for the margin loan for a net value owned by the investor of $216,000.
Application: On the Way Down
Now that we've seen what margin can do on the upside, let's see what the flip side looks like. For that, let's follow the same investor from the tech bubble peak through the following year. Below is a chart that shows the NASDAQ getting crushed with a near 60% loss from March of 2000 through March of the next year.
Assuming our investor had continued to utilize margin, he or she would have lost roughly 60% and paid interest. To keep the numbers simple, let's assume that the portfolio balance was $100,000 and the margin loan was $50,000 at an 8% interest rate. At the peak, our investor held $150,000 worth of the NASDAQ, owning two-thirds of this with the remainder owned through a loan. After one year, the total portfolio would be worth just $60,000, but the margin loan must still be repaid. Including interest charges, the margin loan totaled $54,000.
Looking at these figures, we find that our investor owned only $6,000 of the portfolio (net equity) with the other $54,000 being owed to the brokerage company for the margin loan. In other words, the investor started the year with $100,000 in net equity and finished it with just $6,000 - a net loss of 94%!!!
Wrapping Up
Here's what we've learned: two account types can be established for most non-retirement accounts - cash and margin. Cash accounts result in one-for-one returns while margins leverages those returns while magnifying risk. Marginable securities can be used for collateral to take out a margin loan that carries a variable interest rate and is owed to the brokerage firm. When things are good, margin greatly enhances returns; when things aren't good, margin can wipe out a portfolio.
Critical Thinking
- When should margin be employed? When should it be avoided?
- What level of risk tolerance would be required to stomach a margin loan in good times and bad?
- For whom is margin appropriate? Inappropriate?
- If margin rates are 10%, what level of gain would be required to offset the interest costs? What are the odds of achieving these kinds of returns over time?
- Is margin best used as a long-term or short-term investment tool? Why?
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Posted by: Account Deleted | January 14, 2011 at 01:39 AM
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Posted by: Arvin198624 | January 16, 2011 at 09:28 PM