As you may know, we only invest with money that we have. We don’t borrow to invest, meaning we are not utilizing Smith Maneuver or trading on margin. Why don’t I invest using margin?
Very simple. Because I have seen firsthand how badly one can get burned when trading on margin.
Back in the late 90’s and early 2000’s, a few of our family friends were aggressively buying dot-com stocks. These stocks were doubling or tripling very quickly. Making money was easy. blinded by greed, they started borrowing money from their brokers to buy high risk, high reward dot-com stocks.
The idea is simple. Instead of buying $5,000 worth of stock using your own money, you only pay half and borrow half. Your stock broker then charges interest for lending you the $2,500 and expects the principal to be paid later. Trading using margin allows for multiplied rate of return. Instead of getting 50% return on an investment, you would get 100% return.
The cost involved for trading on margin
If you are trading with Questrade, Questrade sets a margin requirement. The margin requirement is the minimum amount of maintenance excess you must have in your account in order to enter a position, or a percent of the current market value.
If you are trading blue-chip dividend stocks, the margin requirement would be 50% of the market value. Meaning you can borrow up to 50%. If are you trading penny stocks, the margin requirement is significantly higher.
To make money, Questrade charges interest for lending you the money. The interest rates are different depending which type of account you are trading with and the size of your portfolio.
Currently the CAD prime is 2.95%. So trading margin using a CAD non-registered account with less than $100k would cost you 6.45% of interest rate.
Dangers of trading on margin
The good thing about trading margin is that you can significantly increase your rate of return. You can also deduct the interest rate in your income tax filing.
Our family friends that used margin were making money hand over fist when stock prices were going up. But when the dot-com bubble finally burst and stock prices were falling, they lost big time.
When you purchase a stock fully with your own money, you can decide when to sell. When trading on margin, however, you have less control of your investment. You have contractual obligations with the broker. When the stock price starts to go down, you are either required to deposit additional funds into your account to to meet the maintenance requirements, or forced to sell your securities. If you don’t take these actions, the broker will liquidate your position for you to protect themselves.
This is very scary during a bear market and stock prices are gapping down. Often the stock broker will simply liquidate your positions before you can take any actions, and you end up with a huge loss.
These family friends that traded on margin during the dot-com bubble lost more money than they made during the dot-com bubble burst.
It was unpleasant. Getting stuck in this kind of mess created a lot of tensions, some marriages fell apart as a result.
Growing up, I took these lessons to heart and learned to stay on the more conservative side when it comes to investing. Hence, I don’t invest using margin and do not plan to ever use it. If I gamble on an investment, I only invest with money I can afford to lose, and I limit my exposure to this particular investment.
Dear readers, do you invest using margin? If so, what’s your experience so far? If not, why not? I would love to hear from you.