Tuesday, September 11, 2007

A use for margin

Margin is a tool that lets an investor borrow money from his broker to buy stocks. Because you're using borrowed money, you're increasing the leverage of your non-borrowed money. For instance, if you invest $1000 and borrow $500, the total of $1500 is 1.5 times greater than your $1000 alone. That can be good if stocks go up, because you get 1.5 times the profit. Of course, if stocks go down, you lose 1.5 times as much. And in the worst case-, you can lose more money than you invested to begin with because you'll still owe the margin!

Investing with margin can be a dangerous game, much like speculating in real estate. Is there ever a wise time to use margin? Well since I opened a stock trading account for my niece, I've been thinking a lot about investing small sums of money ($50 or so). Let's say that the interest rate on your margin loan is 12% to make the math easyish (margin rates are usually lower).

So, if we're using Sharebuilder, commissions are $4, which means that every time you invest $50 you lose 4/50 = 8%. That's the equivalent of 8 months of margin interest (ignoring compounding), which should tell us there's some probably an equilibrium point around there. So let's look at the total cost of borrowing 8 months worth of investments on margin compared to simply investing each month.

8 months of interest = 8% * 50 + 7% * 50 + 6% * 50 + 5% * 50 + 4% * 50 + 3% * 50 + 2% * 50 + 1% * 50 = 0.36 * 50 = $18.

8 months of commissions = 8 * 4 = $32.

Total amount invested = 8 * 50 = $400

Overhead of margin = 18/400 = 4.5%

Overhead of commissions = 32/400 = 8%

As you can see, despite the huge interest rate, using margin has actually cut our overhead almost in half.

Of course, the other method is to save up 8 months of investments and invest all at once, giving an overhead of only 4/400 = 1%. Now you have to judge whether your investment will gain 3.5% over the next 8 months. Well most people who want to invest are optimistic that the future will always be higher (on average), otherwise they wouldn't be investing! So this actually seems like a fairly wise use of margin. It's something to think about if you are making frequent, small investments!

No comments: