Margin trading is burrowing funds to buy securities like stocks. It is an attractive instrument to amplify the return on investment.
There is one sole advantage of using it. It increases profit. See the table below. Simply an increase of 3.4%. Not a bad deal.
The underline risk of trading in margin is somehow overlooked. In a lot of examples, interest on margin and tax are not factored-in, which exaggerate the advantage of the usage of margin.
A rational investor should evaluate the risk to reward ratio of using margin. Yes, there is a marginal improvement in profit but the risk, should the market goes down, is exponential.
A margin amount of $100,000 with an average market performance of 10% (assuming a margin rate of 5.1%) yields 3.4% profit. While a -10% performance yields -15.1% loss. This gives a risk to reward ratio of 4.4.
I believe it is a too risky endeavor.
Profits dips to negative 15 thousand from a profit of 3.4 thousand.
Long Term Holding
In average market yields 10% yearly. The obvious question is can we hold stock in margin for a long term so that investors don’t have to worry about the yearly downshift of the market.
After all, few percentage increase in profit using margin is surely a good deal.
In this case, the risk is the fluctuation of the margin interest rate. The current margin interest rate of 5.1% is historically low (I have enjoyed 4% rate a few years back). This rate is expected to go up. History tells us that it will, slowly but surely, hit 8-10%.
Should the margin interest rate hit 10%, it will yield a loss not profit. 8.5% is a break-even rate assuming the market performance stays at 10%. By the way, the average market performance is expected to be less than 10% in the future.
So, the math dismiss the possibility of usage of margin for a long term.
However, the short term is still a hit or miss.
The expectation of amplifying profit by using a margin loan is what drives people to be riskier from the lever we already are. Apparently, not only I am guilty of using margin loan, but also I have formulated a strategy of using it (Check it out here)!
All in all, a short term, sensible and affordable margin loan may not be that bad. Keeping in mind that investors with margin loan lose an opportunity to buy more stocks when they are offered at a cheaper price.