Chapter 11

Buying on Margin

My dad was a gambler at heart, so he sold the stock in the company he had helped to build and went to New York to really get rich speculating on stocks on margin. Unfortunately, it was 1929, and on that historic black day in October when the market crashed and Wall Street became a falling-body zone, he lost every penny.

Buying stocks on margin means you borrow money to buy stocks. In 1929, margin buying was the big reason the market had soared. All you needed was 10 percent margin money, which meant you could open a margin account with a broker and buy stocks by only putting up 10 percent of the cost of the stock in cash, with the broker loaning you 90 percent. This multiplied the investor's buying power by 10, driving the market ever higher. Fortunes were made overnight—sometimes in minutes—as a 10 percent move upward would double your money.

That meant that if you wanted to buy 1000 shares of ABC Widgets at $10 a share ($10,000), you only had to put up $1 a share ($1,000), and the broker would put up $9 a share ($9,000). If the stock went up $1 to $11, you doubled your money, because you could sell for $11,000, pay the broker his $9,000 loan, and pocket $2,000. That worked great only when the market was going up. The problem was that the market crashed by more than 10 percent in that one black day in 1929, so margin investors got the only piece of unsolicited advice they were sure to get from their broker—a “margin call.” To protect the loan, the broker would require you to put up more margin money. If you didn't “meet the margin call,” the broker would sell your stock and liquidate your position. This put the investor in an agonizing position—put more money at risk in a falling market, or sell and take the losses on the chin.

On that fateful day my dad met his margin calls, and as the crash gained momentum, he was wiped out again. This happened to uncounted numbers of investors, as the market powers that be (brokers) kept issuing optimistic statements about the overall health of the economy and the market in an attempt to forestall the selling and suck more margin money out of the hands of their clients. They were wrong big time, and bodies began to fall out of tall buildings as speculators lost their life savings and the panic gained momentum, triggering more selling, and the market continued to plunge.

I don't know how many margin calls my dad met; all I know is that Mom said there were margin calls, and she didn't even know what the term meant. Because she was honorably released from life some years ago, I can't ask her.

With that debacle in mind, the Securities and Exchange Commission (SEC) now sets margin requirements much higher than 10 percent: It's currently 50 percent, which makes another 1929 less likely but still means you can lose money twice as fast on margin than you would if you owned the stock with 100 percent of your own money. So even though buying on margin is less risky than in 1929 with its 10 percent margin requirements, it will still double your risk. If the stock falls 25 percent, wiping out half your margin, you will get a margin call. If you don't meet it, the broker will “sell you out,” a term that now has the generic meaning of betrayal—which is exactly what it feels like.

When the market started its implosion in March 2000, margin selling was a factor in the continuing slow-motion crash. A lot of margin calls were met, a strategy that had worked in the previous few years when declines were brief and corrected themselves quickly; but this time the market had risen so high that it was just too vulnerable.

Buying on margin is not for amateurs; it doubles the volatility, and it doubles the impact of market moves, either up or down. Don't do it. I may change that advice when the stock market has finally bottomed out at near-riskless levels a lot lower than it is now, but until that day, it's a no-no.

MEET A MARGIN CALL?

One of my basic rules of investing is, Never meet a margin call. Jim Dines has said wisely, “A trend in motion will remain in motion until it ends,” which means that you should never buy in a falling market. He also said, “Never try to catch a falling safe,” which means essentially the same thing. These maxims sound simplistic and self-evident, but these basic principles will limit your losses, which leads me to one of my wiser maxims: Avoiding losses is the first rule of investing.