Warren Buffett Doesn’t Borrow Money to Buy Stocks, and Neither Should You

Warren Buffett has spent most of his lifetime making money on equity investments. You would think after decades of success, he’d have the confidence to buy stocks with borrowed money. After all, investing with borrowed money is a common strategy for amplifying gains.

There are hundreds of leveraged exchange-traded funds (ETFs) on the U.S. stock exchange, for example. These ETFs attempt to double or triple the daily returns of an underlying index by using debt and financial derivatives.

Individual investors are in the leveraged game as well. One Yahoo Finance-Harris poll suggests that 10% of investors have borrowed money from their brokers to buy stocks.

And yet Buffett, one of the world’s most successful investors, says borrowing to invest is a risk he’s not willing to take — not even when the market’s down and the buying opportunities are plentiful. Here are the basics of investing with debt and why Buffett thinks it’s such a bad idea.

Image source: Getty Images.

Buying on margin 101

Buying on margin is the usual way to borrow money for investing. When you buy on margin, you take a loan from your broker, who is happy to comply because the marginable securities in your investment account will collateralize the loan.

Under Securities and Exchange Commission (SEC) rules, you can pay for up to 50% of a stock purchase this way. You would cover the other 50% with your own money.

The SEC also mandates a minimum maintenance margin of 25%. This means your equity must be 25% or more of your account value. Equity is the value of your investments less your loan balance. Many brokers enforce higher maintenance margins of 30% or 40%.

If a down market pushes your equity value below the maintenance margin requirement, you must deposit money or sell assets to restore your equity cushion. This is the dreaded margin call. If you don’t comply, your broker will sell your stocks to get your account back in compliance.

Amplified gains and losses

Buying stocks on margin amplifies your gains and your losses….

Read complete post here:
Source link