You can buy stocks for half price. That may be just a bit of a stretch, but in a way, that's what you're doing when you purchase with "margin" in a brokerage account. Once approved for a margin account, your broker will allow you to buy stocks using the value of the investment itself — or other "marginable" securities in your portfolio — as collateral. For example, you can purchase $1,000 of stocks for $500 cash and borrow the balance due against the beginning value of the stocks.
Sounds too good to be true, doesn't it? Well, the leverage you gain by using margin can work for you with investments that gain value — and against you when markets fall.
Magnifying the upside
If that $1,000 portfolio of stocks rises in value to $1,500, you've tripled your $500 cash outlay. Of course, you still owe the original $500 balance you borrowed to buy the stock, as well as interest the brokerage firm charges, but the enhanced purchasing power has played a key role in generating your super-sized profit.
Losing more than you invest
Of course, it can also go the other way. If the market turns against you, and your $1,000 worth of stocks sink to a $500 value, you've lost your initial cash investment — and still owe the $500 margin loan, plus interest. If the portfolio keeps losing value you may be subject to a margin call, meaning you'll have to deposit cash or transfer additional securities into the account to cover the loss of value. You can actually lose more than you invested.
Facing a margin call
If you fail to cover the losses, the brokerage firm can sell any or all of your securities to meet the margin call. The term "margin call" is actually a little bit misleading. Your broker doesn't have to call and ask permission at all, or determine your preference of which stocks to sell — she can just liquidate what is necessary to cover the margin.
In a volatile market, margin call security sales can trigger immediate and substantial losses. That means you will have no chance to recover the losses during a subsequent market rebound.
Margin for young investors
Yale professors Ian Ayres and Barry Nalebuff stirred quite a bit of controversy back in 2008 when their research (PDF) offered a startling conclusion: young investors should fully employ margin in order to gain more exposure to stocks.
Ayres and Nalebuff suggested young people could double their stock exposure with margin purchases, gaining diversification over the long term. Then, as the investors aged, they would lower risk with more conservative investments and eliminate the leverage altogether in their "second and third phases" of investing as they neared retirement. The academics claimed that such a strategy would "allow workers to retire almost six years earlier or extend their standard of living during retirement by 27 years."
The concept was eventually expanded into a book, entitled "Lifecycle Investing" (Tantor Media, 2010) which garnered much skepticism and lively debate (PDF).
FINRA, the self-regulatory authority of the securities industry, notes that investor purchases of stocks on margin averaged more than $406 billion — just during the first nine months of 2013 — a 27% increase over the same period in 2012. Such consumer enthusiasm for borrowing to buy securities triggered a FINRA "Investor Alert."
"We are concerned that many investors may underestimate the risks of trading on margin and misunderstand the operation and reason for margin calls," the FINRA statement said. "Investors who cannot satisfy margin calls can have large portions of their accounts liquidated under unfavorable market conditions. These liquidations can create substantial losses for investors."
Borrowing to buy stocks can be a powerful additive to fuel profits. But remember, just a drop can go a long way.
Hal M. Bundrick is a Certified Financial Planner™ and former financial adviser and senior investment specialist for Wall Street firms. He writes about retirement accounts and personal finance for NerdWallet. Follow him on Twitter: @HalMBundrick
Photo courtesy of iStock.