Juggling risks, rewards

Most investors have at one point or another borrowed to invest.  It may be as simple as having a mortgage and an RRSP.  Those people made a choice to begin investing rather than paying more down on their mortgage.  Most investors are comfortable with this type of borrowing.  Receiving an RRSP deduction for the original contribution helps people reduce their annual tax burden while also saving for retirement. 

Many investors also have non-registered investments held outside an RRSP or RRIF account.  Individuals who set up non-registered investment accounts need to make a choice between a “cash account” and “margin account.”

A cash account is a regular investment account in which the investor is required to pay for all investments by the settlement date.  For individual equity purchases, payment must be made within three business days.

A margin account is one in which the investment firm may lend the investor cash to purchase investments.  Any purchases made in the account that exceed the investor’s capital are considered to be “on margin.”  The margin amount is equal to the amount owed to the investment firm and is secured by the investments in the account.

Margin is a term used to describe borrowed money that is used to purchase securities.  Leverage is a similar term that also refers to borrowed money used for investment purposes.  Individuals use margin and leverage with the objective of enhancing investment returns.   It is important for investors to understand the potential risk if the investments do not move in a positive direction.

Margin Illustration

Let’s compare two people that have $100,000 cash to invest.   Mrs. Elliott chooses a cash account while Mr. Lowe selects a margin account.  The risks and rewards are highlighted when we review the outcomes if the stock market returns are positive versus negative for one year.  For purposes of the illustration we compared a stock market gain of 20 per cent with a stock market loss of 20 per cent.

Cash Account

Mrs. Elliott invested $100,000 into equity investments.  Positive returns (market return of 20 per cent) after one year results in the investment increasing to $120,000.  Mrs. Elliott’s return on her original investment of $100,000 equals $20,000 or 20 per cent.  Negative returns (market loss 20 per cent) after one year would result in the investment account declining to $80,000.  Mrs. Elliott would incur an unrealized loss of $20,000 or 20 per cent of her original capital.

Margin Account

Mr. Lowe invested $100,000 of his own equity into an investment account.  Through his margin account he borrowed an additional $50,000 from the investment firm and purchased a total $150,000 of equity investments.  The amount owed to the financial institution is secured by the investments within the account and he will have to pay margin interest (for illustration purposes we assumed the margin interest rate is 7 per cent).  If after one year the investments increased by 20 per cent to $180,000 then the return on his original investment would be approximately 28 per cent after net interest costs are factored in.  We assumed that Mr. Lowe is in the top marginal tax bracket and that he could deduct the interest costs.  The difference in the returns when compared to the cash account primarily relates to the use of leverage.  Let’s look at the outcome if the market loses 20 per cent.  If after one year the investments decreased to $120,000 then the return on his original investment of $100,000 would be a loss of approximately 32 per cent after the $50,000 margin amount is repaid and net interest costs are factored in.   Depending on the quality of the investment in Mr. Lowe’s account he may have received a “margin call” instructing him to either add more funds to the investment account or sell some of his existing positions to cover the losses.

Magnifying Returns

The above illustration highlights that Mr. Lowe has the potential for greater profits during a positive year and greater losses during a negative market year when compared to Mrs. Elliott.  Wealth can be achieved and lost more quickly using leverage and borrowed money.  The equation is easy, greater leverage equals greater risk.

Other important factors to consider prior to utilizing a margin account may include:

  • Tolerance for risk
  • Ability to add funds to the account in the event of a “margin call”
  • Current interest rates for margin accounts
  • The ability to deduct interest costs
  • The tax status of the investments within the account
  • Expectation for market returns
  • The length of time that funds will be borrowed

Flexibility

Individuals with an understanding of both types of accounts may lean towards opening up a margin account.  An individual with a margin account may operate it similar to a cash account and choose not to utilize the ability to borrow on the account. The margin component adds a level of comfort similar to a line of credit at your financial institution.

Some individuals have cyclical cash flows and at the same time would like to keep their long-term investments.  After a period of time some investors may find they have significant unrealized gains that are taxed only when sold.  Rather than selling the securities and realizing the gain, a margin account provides the ability for people to obtain cash from their account without selling their investments.  In many cases utilizing margin prior to selling investments with accrued unrealized gains may be a prudent move, especially if margin is used for only a short period of time.