Stocks: Buying on Margin

Lately, I have been investing in the stock market and have been doing pretty well. I guess a lot of what the experts said about the stock market snapping back was true cause I have definitely been able to experience a lot of gains since the recent market recovery. Even though I feel like I have been taking steps in the right direction, there is always room for improvement. During a conversation with one of my colleagues, I was asked about "margins", which is something that I have heard of but do not fully understand. Of course, this would be a perfect opportunity to educate myself about this procedure as well as write an article about it.

"Buying on Margin" has a very negative connotation due to the fact that this is a practice that contributed to the Great Depression that occurred during the 1920s. From my understanding, many people took at loans to purchase stocks however, when those stocks did not appreciate, many people were left with loans that they were unable to repay. The following information is quoted directly from Wikipedia:

During the Crash of 1929 preceding the Great Depression, margin requirements were only 10%. Brokerage firms, in other words, would lend $9 for every $1 an investor had deposited. When the market fell, brokers called in these loans, which could not be paid back. Banks began to fail as debtors defaulted on debt and depositors attempted to withdraw their deposits en masse, triggering multiplebank runs. Government guarantees and Federal Reserve banking regulations to prevent such panics were ineffective or not used. Bank failures led to the loss of billions of dollars in assets. Outstanding debts became heavier, because prices and incomes fell by 20–50% but the debts remained at the same dollar amount. After the panic of 1929, and during the first 10 months of 1930, 744 US banks failed. (In all, 9,000 banks failed during the 1930s). By April 1933, around $7 billion in deposits had been frozen in failed banks or those left unlicensed after the March Bank Holiday.

As with most things, when there is an unclear understanding of how something works, it is very easy for something that is supposed to be used for positive to turn negative. However, after doing some research, the whole idea of buying on margin is not nearly as complicated.

The terms "buying on margin" basically means to borrow money from a broker to buy stock. The money that is being borrowed is not a conventional loan that you can obtain from a bank. It has a lot more regulations and guidelines that have been implemented to try to help prevent a repeat of the "Great Depression". Below are some of the highlights for a margin account:

1. Typically requires a minimum investment of $2000.
2. Usually requires a set margin maintenance fee (used to insure there is enough "cushion" in the event of loss in stock value)
3. Allows you to borrow up to 50% of the purchase price of a stock.
4. This account typically carries an interest rate imposed by the broker on borrowed funds.
5. Penny stocks, OTCBB (Over-the-counter bulletin board) and IPO (Initial Public Offering) stocks do not qualify for margin purchases.

With all of these requirements, it is hard to see the benefits of having a margin account. However, the example below can illustrate why this account has the potential to return great rewards:

Let's assume that you have $5000 in your cash account. You want to purchase a stock that is worth $10 and you believe that it will double in the matter of a year. Instead of limiting yourself to $5000, because you have a margin account, you can purchase $10000 worth of the stock (borrowing up to 50% [maximum] of the purchase price of the stock). In a year, the stock ends up doubling from $10 to $20 and you decide to sell the stock. So the value of the amount of stock you own goes from $10000 to $20000, however, you have to pay back $5000 + interest which is the based on the original amount that you owned. For our example, let's assume that there is 0% interest, resulting in a net profit of $10000.

If you had just used a regular cash account, your profit would have only been $5000.

Margin Account:

Initial Cash Investment: $5000

Amount Borrowed: $5000

Initial Investment Amount: $10000

Final Investment Amount: $20000

Net Profit (Final Investment - Amount borrowed - Initial Cash Investment) = $10000

Cash Account:

Initial Cash Investment: $5000

Amount Borrowed: $0

Initial Investment Amount: $5000

Final Investment Amount: $10000

Net Profit (Final Investment - Amount borrowed - Initial Cash Investment) = $5000

As you can see from the above example, it seems like a really good idea to proceed with investing using margins due to the fact that the return on investment is double of what it is by using cash alone. However, it would be irresponsible to just provide the possible benefit of the accounts without discussing the cons of this type of account.

In the case that your thoughts were incorrect about the particular stock in the previous example and instead of the stock doubling in value, it was halved, things change drastically. Let's review the previous example using these new numbers:

Margin Account:

Initial Cash Investment: $5000

Amount Borrowed: $5000

Initial Investment Amount: $10000

Final Investment Amount: $5000

Net Change (Final Investment - Amount borrowed - Initial Cash Investment) = $-5000

Cash Account:

Initial Cash Investment: $5000

Amount Borrowed: $0

Initial Investment Amount: $5000

Final Investment Amount: $2500

Net Change (Final Investment - Amount borrowed - Initial Cash Investment) = -$2500

As you can see, in addition to the potential for growing your profits exponetitally, you also expose yourself to the potential to grow your losses in the same manner. One more important thing about margin accounts is that the broker reserves to the right to issue a margin call in the event that the value of the stocks has decreased below the threshold of the margin maintenance fee. Since the stocks that are purchased are held as collateral by the broker, they can force the investor to prematurely sell these stocks in the event that the investor's account goes below a certain amount.

An example of this is the following:

Initial Cash Investment: $5000

Amount Borrowed: $5000

Initial Investment Amount: $10000

Margin Maintenance Fee: 25%

Final Investment Amount: $7500

Actual Margin Funds: $2500

Marginal Funds Required in the account: $1875

With the stock price being reduced to $7500, the investor is required to have at least 25% of margin equity in the account. So, the investor is required to have 25% * 7500 of margin money in the account, that amount is $1875. The broker would not issue a maintenance call on this money due to the fact that there is $2500 of margin money in the account exceeding the required amount of $1875.

If the margin maintenance fee was increased to 40%, the marginal files required for the account would be increased substantially. See below for the new requirements:

Initial Cash Investment: $5000

Amount Borrowed: $5000

Initial Investment Amount: $10000

Margin Maintenance Fee: 40%

Final Investment Amount: $7500

Actual Margin Funds: $2500

Marginal Funds Required in the account: $3000

As you can see, the broke would initiate a margin call this margin account to make sure that there is coverage for the amount of money borrowed. This will either result in the investor depositing more money into the account to cover for the call or if the investor does not have the money to the deposit, will result in the broker selling the stocks (investor's permission may not be required).

This defeats the "buy and hold" strategy to attempt to wait out negative swings in stock as the investor may be forced to sell their stock prematurely.

Although this is an advanced topic, it is good to have a bit of an idea of some of the tools that are available to enable you to obtain financial freedom quicker. Please let me know your comments about buying on margin and some of the experiences you have had with "buying on margin".

Stay Disciplined!

Lessons learned from Investing during a Recession

“Do not brood over your past mistakes and failures as this will only fill your mind with grief, regret and depression. Do not repeat them in the future.” ~Swami Sivananda

With the stock market at unprecedented lows, it gets more appealing every day to invest into the stock market.  There is always the underlying fear of whether or not I will immediately lose more money (that I have already lost) from investing.  After reviewing so many outlooks from different "experts" and "analysts", the general consensus is that it is a great time to buy stock.

Well, is it really a good time to invest?  Well, the stock market is roughly 50% of the level it was at during its peak.  Also, it seems that a lot of bad news has been dispersed over the course of the year, which means good news has to be around the corner right?  Unfortunately, I could not find out what was going to happen tomorrow after looking into my magic crystal ball.  After all, if I was able to do so, my NCAA bracket would be in a lot better shape than it is right now.  

So what is the secret to excelling in the stock market?  Any person who has read an investment book or have watched a financial channels knows that the secret to investing in the stock market is to "buy low and sell high".  Although that is easy to say, what does that really mean?  What do you consider a low price for a stock?  How much money do you consider to be "high"?

I think that a lot of people realized from the previous years that it is really easy to lose money in the stock market.  Especially with new investors, who invested in the peak of the stock market, we are really discouraged about how quickly money disappeared.  However, most seasoned stock investors realize that there are many opportunities to invest wisely and make some money in the process.

Although I have not officially studied investing or received any formal training on the subject, I have learned some lessons from the previous market.  Below are some of the lessons learned:

1. Buy Low
• Although this may seem like an obvious point, it is surprising how hard it is to actually buy a stock at a low point.
• From my personal experience, one usually buys a stock on the way down, however, it is after the initial dip from a previous high which may not be the lowest point of the stock.
• Reviewing the stock's 52-week low and even daily low is helpful when determining a "low" price to purchase a stock.
2. Sell High
• Once again, another obvious point that many cannot seem to get right
• One would like to sell a stock for a profit over the price that was originally paid, however most hold on to a stock trying to break even from the original stock price plus the commission for the buy.
• Very rarely does a stock give you a massive return in a short time, however over time, the potential for that stock to give you those types of returns are possible.
3. Stock prices are based on emotions, not always on facts
• Unfortunately, the average stock investor is typically "along for the ride".
• There are many big time investors (investment bankers, hedge funds, mutual funds, etc) that sway the price of a stock.  The average consumer does not really affect the price of the stock by buying and selling.
• Just because a stock has good news, does not necessarily mean that it will go up.  The same goes for the converse of that, bad news does not necessarily mean that the stock price will go down.
4. It is impossible to time the lowest price of a stock
• Timing a stock is almost near impossible.  It is a better idea to purchase a stock at a price that you are comfortable with.  Honestly, when a stock is being purchased, it is literally buying a piece of paper that you are assigning a value to.
5. Do not watch your stock everyday
• Watching a stock everyday will cause you to be stressed out.
• It is best to set a limit or a stop limit order to purchase a or sell a stock.

I know these points are not necessarily the most profound and can even seem like common sense, however it took me a year of investing and losing a lot of money to fully understand these principles.  Hopefully, this will help you to understand the market a little better and will prevent you from making some of the same mistakes I have made.

If you have any other life lessons you would like to share about investing, please leave them in the comments below.  Stay Disciplined!

The Best Return...Investing in your Future

“When it comes to the future, there are three kinds of people: those who let it happen, those who make it happen, and those who wonder what happened.” -John M. Richardson, Jr.

We are definitely in some times of great uncertainty right now. The housing market is in shambles, the stock market is not much better and more than ever people are questioning the government's ability to bring us out of this situation. Well to be quite honest, no matter who gets elected this coming November, no matter how much change each respective candidate promises us, the real change is not going to happen until we decide it to happen.

So how are we supposed to accomplish this change?

A change can start right now when you commit to investing in yourself. As I have tried to explain in the previous articles, we are our most important asset because we each hold unlimited potential to what we can accomplish. Due to this, we should use our potential to accomplish our goals by investing in our future.

1. Take calculated risks
• There is a difference between an investment and gambling. Note the differences in the definitions below:
• Investment: the investing of money or capital in order to gain profitable returns, as interest, income, or appreciation in value. (Source from Dictionary.com)
• Gamble: to stake or risk money, or anything of value, on the outcome of something involving chance (Source from Dictionary.com)
• There is no mention of "chance" involved in investing which means that with a sound investment strategy, you are almost guaranteed a reasonable return on your money. Understand that one must invest in knowledge on your different options for investing and the risks associated with each option.
  
2. Give 110% in everything you do
   
• I always like to think of the saying "Go hard, or Go home!" when I am not feeling as motivated about doing work. It is a classic statement because it is so true. Unfortunately, we all get tired and lose motivation every once in a while, however, we do not get a second chance at life. If we do not push forward and do the best we can everyday we have the chance to, there is no telling of what opportunities we may miss. We should never be mad at ourselves if we have done the best we could and gave it all that we got!
  
3. Help Others
• Paying it forward may one day pay you back.
• If you ever receive the opportunity to help someone out, take advantage of it and do it. We never know how some day that person (or someone else) will return the favor. Also, must realize that we are very fortunate to offer assistance to someone else because with the state of this economy, we never know when the shoe will be on the other foot.

This concludes my series on "Investing in Yourself". I hope that we begin to realize that we are our best asset and by increasing our stock price, we will be able to increase our overall situations as well as our economy. I will resume talking about personal finances and continue to share my experience as it happens but I really hope that we become more aware of the true power of change each of us possess.

As the quote says at the beginning of this article, there are three types of people...which one are you?

"You Won the Lottery! Now What?"

At one point or another in our lives we have all sat and daydreamed about what it would be like to inherit or win a large sum of money. The vast majority dream of buying lavish gifts or taking trips all over the world. The fact is we oftentimes think of the present and dismiss planning for the future. The cold reality is that a a million dollars nowadays can be spent in the blink of an eye if not carefully managed. Believe it or not there are countless stories of those who have struck it rich only to find themselves bankrupt a few years later.

In this article, I will touch on four basic principles that will guide you in managing your finances before you make that impulse decision to take that exclusive spaceship tour of Mars. If or when the day comes that you find yourself on the receiving end of a cash windfall, you will be much better equipped to handle that money much more confidently and intelligently.

Know your money….inside and out.

"When you fail to plan, you plan to fail"

This may sound basic to most, however, this is a key step that many neglect which leaves them not only worse off than before they had acquired their wealth, but deeply depressed as well. What many fail to realize is that there is an emotional toll that comes with handling large amounts of money and with that many relationships can be affected for the good or bad. You must understand that you are in complete control of your finances and that you must not let outside influences affect how you make decisions.

As a rule of thumb, I suggest not doing ANYTHING with your money for at least one month. It is during this time frame that emotions and impulses run high and when the road to financial turmoil begins. During this time, write down on paper a detailed list of what you plan to do with your money and the costs associated with each activity. Be sure to consider the pros and the cons about each decision and weigh each option carefully. There is a psychological advantage to doing this in that you now have a sense of ownership over your finances

First things first, you absolutely must assemble a "power" team of financial professionals.

This is the downfall of many who strike it rich in the first place because they feel as though they can do it all alone. It is imperative that you put together a highly-qualified group of financial gurus who have experience with working wealthy clients. At minimum the core of your team should include a CPA (certified public accountant), financial adviser, investment adviser, and estate lawyer.

I suggest interviewing 3-5 prospective advisers for each area of expertise. Some of the information you should get out of the interviews include outlining some of the successes of past clients, the credentials of their portfolio, and all fees associated with their services. This is not to say that you can now relax and take a hands-off approach to your money.

Stay actively involved and continue educating yourself with the knowledge of these advisers at your fingertips. Engage yourself in every decision that is made and ask questions when things aren't clear to you. If you are not 100% satisfied with their services you have the right seek another adviser.

Please note that this step is typically reserved for those who have the means to afford hiring a group of professionals. If you do not have the financial backing to afford a power team of financial professionals, do research on each of those occupations to at least understand how each professional is helpful in regards to your finances.

Pay off all debts starting with the highest interest debt first.

This step is self-explanatory, however one that is often overlooked. Many people focus their energy on accumulating more debt instead of eliminating the ones that they currently have. Contrary to popular belief, all debt is created equal.

In my book there is no good or bad debt. All debt prevents you from maximizing your overall net worth and wealth potential by minimizing the money that you have at your disposal to invest and save. With that being said, pay off all debts (credit cards, student loans, etc.) with the highest interest debt first. As Dave Ramsey states…"Debt is dumb" and "Cash is King!"

Invest for the future

This doesn't just mean your own future, but that of others as well. As the old adage goes, "with large wealth comes large responsibility." With your newly acquired wealth you now have the power to leave a lasting impression for many generations to come. The possibilities and opportunities to change lives are endless.

Consider immediately opening up trust funds, ESA's (Educational Savings Accounts), or Roth IRA's for your children and grandchildren. Donate to an organization that is near and dear to you heart (Charitable contributions are great tax write offs!). Whatever it is, make it your mission to create a legacy of giving that can passed down for
years to come.

The Investor's Mindset (Introduction)

Getting in the mindset to invest has been a challenging experience. Dealing with the challenges of wanting to keep up with the Jones's, being able to gracefully accept a gain in stock and dealing with the humbling effects of losing half of my total investment (in that very same stock) has caused me experience a roller coaster of emotions. The most important thing to note during this experience is that through each of these times, one goal has remained in my mind:

"Retire comfortably by age 45"

Before investing, I find that one needs to set a goal. Whether it be to purchase your dream home, become a millionaire or just retire earlier than the "status quo", a goal is needed to keep the focus during the times of emotional instability caused by the ups and downs of life. This mindset is taken from the motto, "It's easy as P.I.E."

• Plan
• Implement
• Evaluate

Basically, as long as you "Plan, Implement and Evaluate", you can accomplish whatever you set your mind to. With that said, I have decided in my mind that my goal is to retire comfortably by age 45.

After deciding what your goal is, you must define it. "Reitre comfortably" to me means to be able to have enough money to sustain a lifestyle that is comparable to my life now. Understand at the moment as a 23 year old bachelor, I do not have much responsibility. However, with a wife, children or whatever other responsibility I may have, I want to be able to spend money using my debit card without having to check my bank statement every month and possibly overdrafting my account. With this understanding, I decided to look at my current allocation of funds to all of my expenses and calculated that "comfortable" at age 45 would require me to have at least be 130% of that per year for at least 40 years.

Now although there is little rhyme and reason as to why that number was chosen, it gives me an actual tangible figure that I can set as my goal. To determine how I will reach my goal, I used sites like BankRate.com to calculate different scenarios and figure out how much money I need to save per month in an investment suitable for my goals. In addition to that, I have read books (Investing for Dummies), countless blogs and magazines and have literally surrounded myself with investing and finance. After putting all of this information together, I finally developed an investment plan and have come up with my means to reach my goal.

I will begin to detail my saving strategies as well as provide other information that I find useful in the journey to obtain my financial goals. This blog will also continue to have the notes from each of our meetings and may even have a special guests to contribute their own personal finance goals and means to obtain them. Overall, I hope that you are able to use the information here to assist with obtaining your financial goals. Stay tuned...