The power of margin, its ability to magnify growth, and why it rarely helps in a buy & hold portfolio.

Margin is built into nearly all brokerage accounts as a standard feature. There are some exceptions of course so as you begin to build a trading strategy it is wise to check with your brokerage to see if margin is turned on for your trading account.

If you aren’t familiar with the term, margin is a loan. With margin, your broker will loan you an amount typically equal to what you have as a liquidating value in your account including cash and holdings. So let’s say you begin with $2,000 in your investing account. With margin, you’ll have $4,000 available to invest.

Let’s say you buy Apple with that $4,000 and it goes up by 10% due to some big announcement.

The gross profit on that investment is $400. But because you really only invested $2,000, the real performance is actually 20%!

Standard Margin allows you to theoretically increase returns two fold!

But before diving into margin with abandon, one must thoroughly understand the risks with margin.

To start, that two fold increase works both ways. It can magnify profits but it can also exaggerate losses.

Let’s revisit the Apple investment and let’s say Apple missed their income guidance.

Let’s say your investment loses 10% due to these factors.

In truth, because of margin, your loss will be -20%!

There’s another problem with margin related to interest rates. Since margin is a loan, brokers charge interest on margined funds. Interest rates charged on margin can eliminate any gain you might have by putting margin to work.

For example, Charles Schwab currently charges around 8% for margin. If you used that margin as a part of a “buy and hold” strategy with the S&P500, your performance gains must be offset by the interest costs. Since 1970, the S&P 500 has generated a 25 year annualized return of 9.71% INCLUDING the Great Recession. So, if you subtract the 8% for margin, your real gain would be roughly 1.71% per year.

Subtract out inflation and taxes and using margin becomes a zero-sum game.

Then there’s also the risk of a dreaded margin call.  A margin call results when you suffer significant losses on your portfolio where your liquidating value is below a certain threshold.

Brokerages will require that you provide funds to your account to strengthen its liquidity and they typically require that these funds come from outside sources.  If you are unable to comply with a margin call your investments can be liquidated and your account can be closed.