This article was inspired by a marketing email I recently received from Wealthsimple. The subject line read: "Coming soon: margin trading". The email goes on to say "Margin trading can help you boost your buying power by borrowing against your portfolio. Applying for your account is fast, hassle-free, and there are no hidden fees. Best of all, our margin interest rate are as low as prime - 0.5% — lower than what you’d pay at your bank." In fairness to Wealthsimple, the email further explains what margin trading is, how it works, and what some of the risks are to using margin.
It really got me thinking more about margin and leverage and especially the surprising findings regarding who can benefit the most from using margin and leverage.
What is Margin and Leverage?
Margin investing refers to borrowing funds from a brokerage firm to purchase securities, using investments like stocks and bonds already in your account as collateral. This allows you to buy more investments than you could with just your own money. The plan being that the investment will appreciate enough to repay the margin loan with interest, leaving a net profit.
Leverage is really the same thing as margin, but more broadly refers to using other forms of borrowed money such as a loan or line of credit to increase investment capacity.
Why use Margin and Leverage Investing
The main advantage of margin and leverage investing is the potential for higher returns. By using borrowed money to increase the size of an investment, the gains from successful investments are also magnified. For example, if you have $10,000 invested in stocks and those stocks rise 10%, they are now worth $11,000 and you have earned a return of $1000. If you had borrowed another $10,000 to invest, you would have earned $2000 (less any interest owed on the money you borrowed).
As a side note, interest paid for investment purposes is generally tax deductible. In Canada, specifically, interest paid on money used for the purpose of earning income from a business or property with a reasonable expectation of profit is tax deductible. Investments in stocks falls into this category and thus the interest is tax deductible.
The Risks of using Margin and Leverage Investing
Just as margin or leverage can improve gains, it can equally magnify losses. If your investment decreases in value, your loss is greater than it would have been without leverage. Margin accounts also face the possibility of a margin call. If your investments fall below the required maintenance margin level, your broker will demand additional funds or liquidate part of the portfolio to meet the margin requirement. This can force you to sell assets at unfavorable prices.
Using margin or leverage also incurs interest costs, which reduces the net returns of an investment. Interest rates used for leverage can be relatively high, and can rise suddenly (as they did a few years back) which cuts into potential profits.
The added volatility of leveraged investments may also lead to undue stress and poor decision making. When large swings in value occur, you may feel pressured to make impulsive decisions, like selling prematurely or doubling down in an attempt to recover losses.
Finally, leverage can lead to rapid depletion of your wealth if investments don’t perform as expected. In highly leveraged positions, you may even face long-term financial setbacks undermining future financial plans.
Should Retail Investors use Margin and Leverage Investing?
The short answer is that retail investors (again, this means regular folks like you and me) should probably not use margin or leverage.
If you truly understand the risks of using leverage, have a good understanding of investing, are disciplined, have access to cheap borrowing (such as a home equity line of credit), and you have sufficient capital to cover potential losses, you may be an appropriate candidate for using leverage.
There is also one very interesting corner case in favour of using margin and leverage as noted in the paper Life-Cycle Investing and Leverage: Buying Stock on Margin Can Reduce Retirement Risk by Ian Ayres and Barry Nalebuff.
In this paper, the authors argue that young investors should consider using moderate levels of leverage (e.g., a 2:1 ratio, or no more than 50% of your existing investments) to buy stocks early in life, as this increases equity exposure when you have fewer assets, potentially leading to greater wealth accumulation over time. By using leverage early on, young investors can build a more consistent level of stock exposure across their full investing life, rather than having that exposure concentrated later in life when they have better saving prospects. They further argue that spreading the investment journey over a longer period through use of leverage actually reduces the overall risk of poor market timing.
Conclusion: Weighing the Benefits Against the Risks
Margin and leverage investing offer a double-edged sword for investors, presenting both significant upside potential and substantial risks. While these tools can supercharge returns, they also come with more risks such as heightened volatility, the possibility of greater losses, and the need to carefully manage interest costs and borrower requirements.
For most retail investors, leverage should be approached with extreme caution and only with a healthy dose of experience. Young investors, however, have more reasons to use leverage and may wish to consider this in their overall investing arsenal.
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