Should You Buy Stocks on Margin?

Below are three questions that may go a long way in answering this question, says Pat McKeough of The Successful Investor.

From time to time, investors ask us questions to which there is not a simple yes-or-no answer. One of these is whether buying stocks "on margin" is a good idea. That is, should investors borrow money from their brokers to buy securities?

This strategy is reasonable in some circumstances, but it carries more than the usual amount of risk.

The main cost involved with buying on margin is the interest on the money you borrow. Plus, when you sell a security that you've bought on margin, you must first pay back the loan from your broker.

Interest rates remain low. That does add to the appeal of buying stocks on margin. However, there are a few things to keep in mind if you're thinking about borrowing to buy stocks:

Maximize your margin investing with our three-part strategy. If you could stick to a strategy of buying on margin when the market hits bottom, stay margined as the market rises, and sell out at the peak, you could very quickly build an enormous fortune. But the simple fact is that no one has the sense of superhuman timing necessary to consistently succeed in that.

That's why we continue to recommend that if you are going to use margin to invest, it's all the more important to stick with our three-part investment approach: mainly invest in well-established companies; spread your money out across the five main economic sectors; and avoid stocks that are in the broker/media limelight.

If you rigorously follow this stock investing advice, you stand to make money over long periods. With margin, you'll make even more.

Increased leverage can work for or against you: The main risk of buying stocks on margin is that it increases your leverage. Leverage works two ways: It magnifies your profits when the market moves in your favor, but it magnifies your losses just as surely when the market moves against you. That's because the amount you owe on your investment loan stays the same, so every dollar lost in your portfolio comes straight out of your equity.

Buying stocks on margin has tax advantages: When you buy on margin, you'll be able to write off your margin interest in full against ordinary income in the current year. However, you'll pay less than ordinary income tax rates on dividends from Canadian stocks, thanks to the dividend tax credit.

 Above all, you'll defer all capital gains taxes until you sell, and only pay taxes on capital gains at half the rate you pay on ordinary income.

A three-part test to see if margin investing is for you.

Buying stocks on margin is certainly not for everyone. That's why this strategy only makes sense if you can answer "yes" to all three of the following:

1. You are in the top tax bracket and expect to stay in it for the foreseeable future;

2. You follow our conservative three-part investing approach (see above);

3. You invest consistently over a number of years, and resist the temptation to increase your margin borrowing when stocks have risen, or reduce it when prices have dropped.

If you are unsure on even one of these points, you are better off not to take any chances buying stocks on margin.

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