What Are the Disadvantages of Buying Stock on Margin?
Understand the significant financial risks and operational pitfalls of buying stock using borrowed money.
Buying stock on margin involves borrowing money from a brokerage firm to purchase securities, effectively using existing assets in your account as collateral for a loan. This practice allows investors to acquire more securities than they could with their available cash, thereby increasing their purchasing power through leverage. While leverage can amplify potential returns, it also magnifies the inherent risks. This article will explore the disadvantages associated with buying stocks on margin.
Magnified Financial Losses
Using borrowed money to buy stocks introduces the potential for amplified financial losses. When an investment financed with margin declines in value, the investor is not only losing their own capital but also remains obligated to repay the full amount of the borrowed funds. This means that a relatively small percentage drop in the stock’s price can lead to a much larger percentage loss of the investor’s actual money.
Consider an example where an investor uses $10,000 of their own money and borrows $10,000 on margin to purchase $20,000 worth of stock. If the stock’s value falls by 25%, the total investment is now worth $15,000. After repaying the $10,000 loan, the investor is left with only $5,000, representing a 50% loss on their initial $10,000 capital, even though the stock itself only declined by 25%. This scenario highlights how losses can exceed the initial investment, a risk not present when trading solely with cash. The investor remains fully responsible for the borrowed amount, regardless of how poorly the investment performs, meaning one can lose more than their original deposit.
The Mechanics of Margin Calls
A margin call is a demand from the brokerage firm for the investor to deposit additional funds or securities. A margin call occurs when the equity in a margin account falls below a specific threshold, known as the maintenance margin requirement. Brokerage firms set these requirements, often around 25% to 30% of the securities’ value.
When a margin call is issued, the investor faces immediate pressure to meet the requirement. The brokerage firm typically provides a short timeframe to deposit the necessary cash or securities. Failure to meet this demand triggers consequences. The brokerage firm has the contractual right to liquidate assets in the account without prior consultation or additional notice to cover the deficit. This forced liquidation can occur at an unfavorable time, locking in losses and preventing any potential recovery.
Interest Charges and Other Costs
Buying on margin incurs direct financial costs that can erode investment returns. Brokerage firms charge interest on the money borrowed. This interest accrues daily on the outstanding loan balance.
Margin interest rates are variable and typically tied to a benchmark rate. These rates can fluctuate, and higher interest rates will increase the cost of borrowing, placing a greater drag on potential returns. For instance, typical rates can range from around 6% to over 13% annually, depending on the brokerage and the loan amount. The accumulating interest must be paid, and it can significantly impact the net profit or loss of a margin trade.
Brokerage Firm Actions and Investor Control
Trading on margin diminishes the control an investor retains over their own account. The margin agreement grants extensive rights to the brokerage firm. These rights allow the firm to take unilateral actions to protect its financial interests, often at the expense of the investor’s preferences.
If the equity in the margin account falls below the maintenance margin requirements, the brokerage firm can sell any securities in the account to meet the deficiency, even without contacting the investor beforehand. The firm also has the discretion to choose which securities to sell, potentially liquidating positions the investor intended to hold for the long term or believed would rebound. This loss of autonomy means an investor might be forced to realize losses on holdings they preferred to keep, interrupting their investment strategy.