I have made tons of stupid investment mistakes in my life. Afterwards, I picked myself up, dusted myself off, learned from my mistakes and continued to invest regularly. Even though I learned valuable lessons, I shudder to think how much more my net worth could have been today if I had not gotten greedy. Before we dive in on this mistake (and what margin is) there are three key investment principles that I have learned the hard way.
- Invest heavily when the market is down
- When the market is up and you’ve had a great year, don’t get greedy. Do not change your behavior and don’t overextend yourself chasing even bigger gains.
- Disciplined investing beats out everything else. I am a fan of consistent investing (every week, month whatever, no matter where the market stands.) Even with all the mistakes I’ve made, this has allowed me to build a significant investment portfolio.
I violated the second rule by using margin.
What is Margin?
Margin is a loan that you take on your brokerage account (the one you use to buy stocks). It allows you to purchase additional stocks that you may not have the cash to buy. Robinhood is a popular brokerage app that I highly recommend and use myself. It offers the opportunity to buy stocks without commission and has very competitive offerings for investors. They will allow you to take up to 150% in margin. If you have 30K of hard saved money, you can buy an additional 45K worth of stocks. The stocks in your brokerage account act as collateral on the amount that you bought.
If the market falls, the stocks that are being used as collateral will fall in value. This will force you to put cash into your account to cover the losses. Remember, if you are using the 45K mentioned above you will have 75K of stocks that you are exposed to. Your own 30K plus the 45K bought on margin. If these stocks fall losses will amount insanely quick because you are exposed to so much stock.
The loan is not free. Robinhood currently charges 2.5% on money for the loan (this is well below what other brokerages charge). You are responsible to make the interest payments monthly and the interest occurs daily. A quick example:
45K * 2.5%= $1125 in annual interest
$1125/ 365= $3.08 how much you owe for each day you are using the borrowed 45K
You are also responsible to return the money you borrow on top of this interest cost. If your 45K loses 10% you will owe $4500. You will need to add cash or sell other stocks in your account to cover this loss. Imagine how damaging this can be when the whole market is down, and you need to start selling a ton of stuff when everything is down just to cover the loss from margin.
As you might be starting to realize, margin allows you to own a lot more stock. This will allow you to capture a lot more upside but will expose you to a lot more downside depending on the stock you buy. My stupid ass realized only half of this and decided that I was able to use margin as a tool to help me increase my gains. Let’s reconstruct my genius trade so I can forever be made fun of on the internet.
Reconstructing The Trade
For a long time I have always loved dividend stocks. These stocks will pay you (usually quarterly) a set amount per share. Dividend stocks tend to be more mature companies who don’t have as high growth as younger companies but produce cash flow and are more stable. Collect enough of these bad boys and you will make some serious passive income.
I thought that I could use margin to buy dividend stocks before their ex dividend date. This is the date at which they record all the shareholders who will pay the next dividend to. Basically you need to own it at the ex dividend date to get the next dividend payment.
If I owned a ton of stock on margin at the ex dividend date I would get a large dividend payment. Then I would wait for the market to return to the price I bought it at or higher and sell the stock I bought on margin.
One of the oldest and most renowned dividend stocks is Altria (MO). It is the largest tobacco company in the US and has been paying an increasing dividend every year for over 50 years. I thought that Altria’s stability made it a prime target for this strategy. It’s stability and resilient industry would allow me to avoid any major stock movements while I used margin to capture their dividend.
I used margin to buy 562 shares of Altria over the course of a few weeks. I am not sure what the average price was but it was around $43.00
So there I was fat, dumb, and happy at the end of February 2020. All I had to do was wait for the ex dividend date on March 24th and I would be collecting .84 cents per share on 562 shares!
The only thing that could ruin this strategy was a completely random, once in a century, event that would affect me in the time I owned the shares using margin. And what was the chance of that happening?…..
Look Out Below
How bad could it get? Altria is a stock that’s known to be safe during recessions and I was only owning it for a little more than a month.
That bad………… Note this is two days before the ex dividend date. The sky was falling. I am usually not an emotional investor but I was starting to get really worried. At this point the shares had decreased to $36.00 a share and I was getting close to a margin call. That’s where you need to sell other stocks or add cash to stop the brokerage from selling your margin shares. Yeah, so much for buy and hold, with margin you are literally forced to sell if everything goes south like it did with COVID in March. Let me emphasize that once more…
You will be forced to sell shares you borrowed to lock in the losses when everything is down.
That’s exactly the worst move you can make and margin forces you to do it.
I still got a $472.00 dividend though so that’s cool I guess. After factoring that in, I only lost $7,459.00 on this trade. That includes losses taken on other stocks I had to sell to cover the loss from margin.
Let’s Both Learn From This Mistake
When the market is doing well (like it is now) people who have never been interested in investing will start telling you how much money they made on stocks like Tesla. They may even use margin to make even bigger gains. This is where discipline is really important. If you get caught up in the rush you will absolutely get burned.
Borrowing against your investments has no place in a wealth building strategy. No investment is worth the risk if it can wipe out years of hard saved money in a matter of hours.
The best thing you can do is remove yourself entirely. Humans are so bad at making investment decisions that there is a whole field of study devoted to it called behavioral finance. Put your investments on autopilot with monthly contributions to index funds. Use your time to do more meaningful things than to follow individual stocks on the market. And when your friends all of a sudden start to brag about how much they made (coincidentally when the whole market has done well), be a good friend and point them to this article. Margin investing can lure you in with upside gain but it’s easy to forget how quickly you can lose control of the situation. Trust me, you don’t want to be the guy using margin when a once in a century event occurs.
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