Intro to Finance: Leverage/Margin

July 16th, 2008 by Potato

The stock market is in the pits at the moment, and I’m seeing values everywhere. I started the year with a bit of cash on the sidelines, and bought in on the downward slide. Now I’m tapped out in terms of cash, but think it’s probably a good idea to keep buying more (not necessarily right away, just a month after my last buy-in, but through the rest of this year and next). Of course, I can’t buy without more cash… or can I? By borrowing money to invest, I can keep buying more stocks/ETFs. If the market is getting close to the bottom and ready to turn around, I could increase my returns substantially. This is known as leveraging.

If I buy $100 worth of stock with $50 of my own money, and $50 of borrowed money, and then next week the stock is up to $110 and I sell, then I’ve effectively doubled my return: I’ve made $10, bringing me to $60 after I pay off the loan, but only needed $50 of my own money to invest. By the stock going up 10%, my return went up 20%.

It’s this magnification effect of leverage that made buying a home such a great investment over the last several years: with 20% or even 0% down, you could grab a home, and even modest increases in price would lead to you walking away with a tasty handful of cash, because you could leverage yourself to a very large degree with a mortgage.

Of course, leverage cuts the other way, too. If my stock went down to $90 instead, and I had to sell there, I’d pay off the $50 loan and find I was only left with $40 — a 10% decline in the stock lead to a 20% decline in my wealth. To lose everything, that stock would “only” have to go from $100 to $50 (a feat CIBC amongst others has managed recently). If it went bankrupt and went to $0 before I could sell, I’d end up with nothing and owe the bank $50, doubling my potential loss from the $50 I had in cash to invest in the first place.

So leveraging is a way to increase your returns, both positive and negative, at the cost of increased risk. I’ve avoided leveraging so far because it just didn’t fit with my risk appetite. Lately I’ve been thinking more and more about it, and am considering whether a 5% leverage (buying $100 of stock with $95 of my own cash and $5 of the bank’s money in the form of a loan) would work for me. In addition to potentially goosing my returns, it might also help me build up my credit rating. On the other hand, the financial markets are a mess right now, so that risk aspect is very clear.

When buying on margin like this, the risk can be magnified even more by what’s known as a margin call. You see, if you buy your leveraged positions with a margin account at your broker (as opposed to taking out a general loan or home equity line of credit), then there are rules as to how much money they can loan you — you must have skin in the game. For example, if the limit is that you must front the cash for 50% of the price of the stock, then you need to keep that much equity handy. You could, for example, put in $60 and borrow $40 to buy $100 of stock. As long as things are going up, then all is hunky dory. However, if a stock goes down to below the threshold then you will have to either provide more cash so that the value of your loan doesn’t go over the limit, or your brokerage will forcibly sell some of your stocks to cover. So if your $100 of stock goes to $80, then your $40 loan is 50% of the value of your holdings. If the stock goes lower to $79, then you are borrowing too much for the equity you have. You will have to immediately (maybe, if you’re a good customer, the brokerage will give you 3 days) provide cash or sell shares to cover the difference. That can really hurt, not only because the leverage has increased your downside risk, but also because the forced sale means you don’t even have the option of waiting out a downturn — your shares will be sold and you won’t participate in any rebound, if it occurs. These margin calls are part of what sometimes drives the stock market to overshoot and oversell a stock — if the stock starts dropping and enough investors find that they don’t meet their margin requirements, they can be forced to sell something, driving it yet further down.

My examples here are quite simplistic — you will naturally have to pay interest on that loan, whether it is from your broker or a separate loan or line of credit. This interest will reduce your bonus gains a bit, and increase the amount you have to pay on the downside. Margin accounts from a broker are generally “interest only”, which keeps the cost of maintaining the leverage low, whereas you’re generally expected to pay back at least part of the principal back with a traditional loan a bank (not sure about a HELOC, I think that is flexible so it can be interest-only if you want it to be). Borrowing to invest, as long as your investments produce income, should make the interest tax-deductible, but I am not a tax expert and in fact this means very little to me given my tax bill as a grad student.

So what are your thoughts on margin and leveraging? I thought I was fairly pessimistic, at least relative to what I was hearing in the media, about what this year had in store back in January. Then things started to get into my value ranges and I started buying. Now things are a fair bit lower than I estimated the bottom would come, so perhaps things will turn around, or at the very least we might see a dead cat bounce. Do you think I should take on the risk of leverage to try to wring some performance out of this market? For a margin account, TD presently charges 5.75% interest to buy Canadian stocks. There are a number of companies out there that are presently paying out that much in distributions or dividends, so I could buy one and have the payments cover the interest while I wait for capital appreciation. On the other hand, the market might continue to go down and down for years to come, and being leveraged would just magnify my losses. That interest rate is also variable, and could go up at any time: possibly quite soon given the fears of inflation lately, adding to the risk. What do you think? Do you have any thoughts on a margin account versus an investment loan or line of credit? To start you off, here are two posts by Canadian Capitalist, Thicken My Wallet on leverage.

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