When it comes to investing, many people aren't aggressive enough with their portfolios, keeping too much money in cash and low-income investments that don't have the potential to grow and produce life-changing returns. Investing in stocks has historically yielded much better results, and even though you have to accept the volatility that comes with the stock market, that's a fair trade-off for those with a long time horizon.
However, it's possible to get too aggressive with your investments. Many brokers allow their customers to borrow money on margin, using their stocks as collateral and allowing them to purchase additional shares. This can improve your returns during favorable times, but there's a potentially catastrophic catch that has snared even smart investors.
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Fear of missing out
The appeal of using margin is obvious during a rising market. Over the past decade, the S&P 500 has risen at an annualized clip of almost 14%, more than tripling your money if you were invested in an index fund that tracked that particular benchmark. However, interest rates were extremely low during the period, making it relatively inexpensive to borrow money on margin.
To see how this might work, take a simple example. Say you have a $10,000 stock portfolio and want to borrow $5,000 on margin to invest. We'll assume that you can get a margin loan at a rate of 4%, and over the next year, the market returns 14%.
If you just invest the $10,000 without margin, then the calculation is simple. A 14% return will leave you with $11,400 at the end of the year.
However, if you borrow on margin, you'll also get a 14% return on that additional $5,000, leaving you with $5,700. You'll have to pay 4% interest on the $5,000 borrowed, giving up $200 of your profits. But you'll still end up $500 ahead after repaying the loan -- leaving you with a total of $11,900, or an effective total return of 19%.
The boost that you can get from squeezing a few extra percentage points of returns from your portfolio can make a huge difference in where your net worth ends up. Compound for 10 years at 14%, and you get about $37,000 for every $10,000 you invest. Raise that to 19%, and the end balance jumps to almost $57,000.
The dangers of margin
Yet as lucrative as margin can be when times are good, it can be devastating when things go wrong. Back in 2015, Michael Pearson was CEO of Valeant Pharmaceuticals, now Bausch Health (NYSE: BHC). He ended up losing his stock in a margin call when his broker sold it to cover loans of roughly $100 million.
More recently, Tesla (NASDAQ: TSLA) CEO Elon Musk has used margin extensively to tap the value of his holdings without having to sell stock and give up the corresponding upside potential and voting rights. The electric vehicle manufacturer's recent share-price decline has some worried about exactly how much he might have on margin and what his potential liability would be if the stock drops much further.
This also happens to ordinary investors. When you look back to the bull market of the late 1990s and subsequent bust in the early 2000s, you'll find plenty of episodes of margin loans going disastrously. An ill-timed decline in shares can force you to sell at the worst possible time -- and potentially keep you from participating in an eventual recovery.
Just say no
Higher returns from margin look great when the market's going up. But the risks involved outweigh those potential returns. You're better off maintaining full control of your portfolio rather than ending up in a situation in which your broker can force you to sell at what often proves to be the lowest price for a stock.
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Dan Caplinger has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Tesla. The Motley Fool recommends Bausch Health Companies. The Motley Fool has a disclosure policy.