As an investor, sooner or later you will run into the term, “buying on margin”.  

You will hear it labelled as a good investment tactic, as a bad investment tactic, as a tactic used routinely and commonly, and as a tactic which is very foolish.

In simple terms, “buying on margin” is simply borrowing money to buy stock.  Usually, you use the purchased stock as collateral against the loan.

Your immediate response is going to be, “Well, I have a loan on my house, a loan on my car, and my student loan.  What’s the difference?”  

The difference is the laws that limit buying on margin, and the dangerous pitfalls and consequences that can easily befall you.  

Rule One for buying on margin:  know the laws about buying on margin.  

You can typically borrow up to 50% of the cost of the stock.  That sounds not so bad – but if you borrowed 50% and the price falls, you will suddenly be in default.  Considering that stock prices routinely rise and fall several times every minute, borrowing 50% almost guarantees disaster.  

If somehow you make it through the day (suppose you only borrowed 45%), it is not uncommon for the price of stock the next day to fall at first.  Again, you could easily find yourself in default.

Buying stock on margin is not like buying a car, where typically the value of a car drops 25% as soon as you drive it off the car lot.  Your purchase of a stock on margin has to stay below 50% throughout any swings the market makes, until you either sell the stock, or you provide more cash to pay off the margin amount.

Rule Two for buying on margin:  only buy on margin in a period when stock prices are generally going up, and your research on the company whose stock you intend to buy on margin shows that the company is and will continue to be in an extended, long term growth period, with a solid balance sheet and steadily-increasing income statements.

At the time of the crash of 1929, there were few legal limitations concerning buying stocks on margin.  When the market collapsed that October, thousands of investors were instantly bankrupt, with debts far beyond what they could ever hope to repay.  Debtors literally jumping out of windows were a reality.

More realistically for you as an investor, buying stock on margin means you do not have to sell stocks you own to buy more stock.

However, also be aware that your broker may liquidate some of your stocks to make up for the loss on a margin buy.  The broker’s choices for liquidation are not likely to be the same choices you would like him to make.  Such a sale not only reduces your holdings, but it can also result in tax money due just like any sale of stock.

In any case, buying stocks on margin is generally a short-term investment.  The interest rate charged for the money borrowed to pay for stocks on margin tends to be fairly high.  Experience shows that margin buying is often a losing proposition, and the likelihood of recovering the money loaned is low.  

That high amount of interest for a margin loan means the investor buying on margin is in a constant race:  will the price of the stock he purchased grow in value more quickly than the cost of the interest on the loan?  

You can easily find yourself paying more money back (combined principle and interest) than the total value of the stock, even if its price went up – but not enough.

Buying stocks on margin only makes sense if the price of your chosen stock is going up.  The whole purpose of buying on margin is to take advantage of a bull market – a time when stock prices are going up.

Obviously, in a bear market – when stock prices are going down – buying on margin virtually guarantees a financial loss.

Buying on margin is often called “speculative trading” – which has no place in the portfolio of an investor intent upon long-term financial success and well-being.  

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