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The Perils of Margin Investing

MoneyWise

Christian talk radio with Rob West

July 19, 2022

Proverbs 21: 5 tells us that, Steady plodding brings prosperity; hasty speculation brings poverty. Nowhere is that more true than with your investments. We’ll talk about that today on MoneyWise. There are two types of margin when it comes to your money. One is good the other is very, very bad. The good kind is the margin in your budget. It’s money left over after paying all of your bills and obligations. We sometimes call it discretionary income. You need this margin so that you can save for emergencies and invest for the future. That’s why we call it good and so does God’s Word. Proverbs 21: 20 says, Precious treasure and oil are in a wise man's dwelling, but a foolish man devours it. Now, the other kind of margin involves your investments, and it’s really a form of gambling. Thankfully, margin investing is generally prohibited in qualified retirement accounts, like your 401k or IRA. But that still leaves regular brokerage accounts, where margin investing is not only allowed, in many cases, it’s encouraged by brokerages. According to Yardeni Research, investors who used margin currently owe around $750 billion dollars. That figure is down from a year ago, so the trend is heading in the right direction but that still leaves an enormous risk for margin investors, especially with the market’s current volatility. MARGIN INVESTING So what exactly is margin investing? It’s when you borrow money from your brokerage to invest more than you otherwise could with your own money. You’re actually betting that the stocks you buy with margin money will increase in value. If they do, you’re a winner, but if they don’t, you’re in for trouble. Here’s an example. Let’s say you inherit $50, 000 from your rich uncle. You can’t put the money in your 401k or IRA because you can only fund those accounts with earned income. So you open a regular brokerage account, like a Fidelity, Vanguard or Schwab. But then you hear about this amazing opportunity to invest on margin. The Federal Reserve allows investors to borrow from their brokerage up to 50% of the purchase price of stock. What does that mean for your $50, 000? It means you can actually buy $100, 000 worth of stock, doubling your holdings. If the stock increases in value, your gains would be twice what you’d make with just the $50, 000. But that’s one giant if. If the stock declines, you’re on the hook for the losses. In theory, you could lose your entire portfolio if the stock went to zero because your initial $50, 000 is collateral against what you borrowed. Don’t think that can happen? In 2000, Enron stock was selling for around $90 a share. A year later after a horrific accounting scandal Enron stock was selling for 26 cents a share. Investors lost billions. Now, why would a brokerage want you to invest on margin? When you think about it, it’s sort of like borrowing chips from a casino to gamble with. A lot of folks would never dream of doing that, but investing on margin is really the same thing. And brokerages make it easy to do because they charge interest on the margin money they loan increasing their revenues. And since your loan is collateralized by the money you put in their risk of losing is practically nil. Now, you must apply to invest on margin, and provide financial details just like you would when you apply for a mortgage, but how hard is that? One popular investing platform, Robinhood, has gotten a bit of a bad reputation for pushing margin investing too hard and earning 5% interest on the margin money it loans. Of course, when the value of stocks bought with this leveraged money goes up, everyone is happy. But when it drops, you’re the only loser, and potentially a big loser. If the value of the stock bought with borrowed money drops low enough, as it certainly did with Enron, you’ll experience what’s known as a margin call. That’s when your brokerage suddenly demands more money from you to hold your investment. That will happen automatically when the value of your total $100, 000 investment drops to $25, 000. That’s the 25% maintenance margin required by law. But many brokerages will issue a margin call well before that. If you can’t come up with the additional funds within what is usually a short time frame, the brokerage can then liquidate your investment meaning they take the money you put in to cover their losses. The key to successful investing is to have a well-balanced portfolio and to hold it for a very long time. Investing requires patience so we can’t urge you enough never invest with margin. The risk is simply too great. On today’s program, Rob also answers listener questions: ● Should you tithe on a 401k? If so, how so? ● What factors determine whether the closing costs on a mortgage refinance are fair? ● How can someone gift an inheritance? ● How does Christian Healthcare Ministries compare to medical insurance? ● Would it be wise to invest in commercial real estate? RESOURCES MENTIONED: ● CHministries. org

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