Personal Investor: The risks of borrowing to invest
When the first opening bell rang in 2018, a record US$581 billion in margin debt was invested in the New York Stock Exchange – up 3.5 per cent from the month before. Similar spikes in the amount of borrowed money being invested in the NYSE have not been seen since 2007, and before that 2000 – just months before major corrections.
Investing on margin can be a double-edged sword. Returns can be supercharged on the upside and losses can be accelerated on the down side. Most brokerages will facilitate margin accounts. Interest rates vary depending on the investment, the client, and interest rates in the broader market.
Stocks bought on margin generally require investors to kick 30 to 50 per cent of the value of the overall investment as collateral. The greater the volatility of the stock, the higher the margin requirement.
Only experienced investors should invest on margin. There are risks in using borrowed money to invest.
If the security falls in price, so does the value of the collateral in proportion to the amount borrowed. If the brokerage demands the borrowed amount to be lowered to reflect the lower value of the collateral, the investor receives a “margin call”. That means the investor must come up with the necessary cash, or sell some of the shares – often at a lower price.
The value of the shares often change from minute to minute. Investors need to keep on top of those changes.
Also, accumulating interest over time eats away at the total investment, potentially creating a real loss. That’s why margin investing is only intended for short-term investments.