Margin Debt: How Investors Lose Everything in The Stock Market

[00:00:00] Speaker 1: Have you ever thought about borrowing money to invest in the stock markets? That's called margin debt. And is margin debt a good idea or is it a bad idea? Well, I would say that there's pros and cons to it. So in today's video, let's review the danger and the benefits of margin debt. So if you didn't know, when you open up a brokerage account or a stock market account, you're going to have the option to borrow money to buy stocks. And we're going to use the Ameritrade platform as an example because, well, they're no longer in existence. So let's just say that you open up a brokerage account on Ameritrade's website or app to buy and sell stocks. Okay. Now Ameritrade is going to give you the option to open up a margin account and borrow money from them. Now, a good question is why does Ameritrade allow you or other investors to borrow money from them? Well, it's because Ameritrade is going to charge you a relatively high interest rate. And of course, they're going to make money off you. And if people have more money in their accounts, then they're probably going to buy and sell more than they would or could, which is good for the company's trading volume. Now, let me explain to you how this works. To put it simply, margin debt is money that an investor borrows from their broker to buy stocks or ETFs on the stock markets. So it's exactly like taking out a loan, but instead of using that money to buy a home or a car, you're using that money to invest in the stock markets. Now, I want to run you through an example so that you can see it for yourself. So imagine that you have $10,000 of your own cash and it's ready to invest. In a standard cash account, your purchasing limit is going to be strictly capped at $10,000, right? But if you open up a margin account, your broker steps in and they're going to offer a deal. They might say, if you put up your $10,000 as collateral, then we will lend you another $10,000. So instantly, your purchasing power doubles to $20,000. But of course, Wall Street doesn't do any favors for free. The broker's going to charge you a set interest rate on that borrowed money, regardless of whether your investments go up or down. Furthermore, the assets in your accounts act as collateral for the loan. So a very good question is, why would anyone take on debt just to buy stocks? And the answer is leverage. Margin debts is going to amplify your potential gains. So let's go back to our example where you bought $20,000 worth of stock and half of that was with your money and half of that was with borrowed money. So in that scenario, if the stock goes up by 50%, then your total investment is now going to be worth $30,000. So you sell the stock, you pay back the $10,000 that you borrowed and that you owe the broker, and then you're going to be left with $20,000. So in this scenario, you just double your initial money, achieving a 100% return on your actual cash instead of the 50% that you would have made without borrowing money. But listen, I just want you to keep in mind that's a scenario where everything works out. But here's where the story gets incredibly dangerous. I just want to say that leverage is a double-edged sword. It amplifies your gains, but it also amplifies your losses. So imagine the opposite scenario. The market drops and your $20,000 investment falls by 50%. So if that happens, then your portfolio is now worth $10,000. But you have to remember that you still owe the broker $10,000 that you borrowed. So your entire personal investments has been completely wiped out and you're going to be left with nothing. But listen, I want you to know that brokers do not sit back and just watch your accounts go to zero. They enforce a strict rule called the maintenance margin. So if the value of your account falls below a certain percentage, then you'll receive the most dreaded notification in the financial world, the margin call. So a margin call is a demand from your broker to immediately deposit more cash into your accounts to cover the losses. And if you don't have the cash or if you don't deposit it fast enough, then the broker is going to forcefully liquidate your positions. In other words, they're going to sell your stocks without your permission, and often it's going to be at the worst possible market prices, just to ensure that their loan is repaid. And listen, I want you to be aware of this, that margin calls don't just affect individual traders. No, it impacts the entire global economy. So when the market is in a bull market and stocks keep pushing higher, investors get overly confident and the total margin debts in the financial system hits record highs. But when the market starts to drop, it triggers a chain reaction. So falling prices cause widespread margin calls. And a lot of investors are forced to sell their stocks if they can't come up with enough money to meet their margin call. And then just think about that, like this massive wave of selling drives prices even lower, like drive stocks even lower, which triggers even more margin calls. And then it's like a negative feedback loop. The domino effect can turn a standard market correction into a violent cascading crash. Now, this is something that I emphasize to my financial community. If the stock market crashes, what do you think is most likely going to happen? Well, in my opinion, the Federal Reserve will come to the rescue. And how will the Federal Reserve come to the rescue? Well, it's my opinion that the Federal Reserve will do what they always do. They'll print trillions of dollars and flood the system with money. And how would that rescue a stock market crash? Well, if you print and inject trillions of dollars into the system, then what are a lot of people going to do with that money? They're going to put that money into the stock markets, and that'll give the stock market a really big boost. And additionally, if there's massive money printing and inflation, then corporations will make more money. They may not make more money adjusted for inflation, but nominally, yes, corporate earnings will go up. Now, let's walk through the sequence of events and see how margin debt plays into this. And let's do an example with a big round number. So let's just say that you have $100,000 in the stock markets. And let's say that the stock market crashes 50%. And your $100,000 goes down from 100k to 50k. And then the Federal Reserve steps in and prints trillions of dollars. And then the stock market recovers to where it was before the crash. And because the Federal Reserve printed way more money than was necessary, the stock market ends up going 30% higher. Now, in this case, your portfolio is up to $130,000 and you're at a $30,000 gain. Now, because you did not borrow money to buy stocks, you were able to weather the storm. You were able to patiently wait for the stock market to recover. And now you've made money. Okay, let's run another scenario. Let's say that you have $100,000 in the stock markets. And let's just say that you found the stock that you fell in love with. You think it's going to make you rich quickly. You believe that's going to go up 10x. And you're like, my $100,000 is going to turn into 1 million. But then you try to become clever, like you get greedy. And you're like, I love this stock. It's like a once in a lifetime opportunity. And you think, wait, what if I borrow $100,000, then I can buy $200,000 worth of this stock. And when it goes up tenfold, then I'm going to have $2 million, which sounds much better than $1 million. Okay, so you do that, you borrow $100,000, you take your $100,000 and the borrowed $100,000, and you buy $200,000 of the stock that you absolutely love. And then the market crashes 50% along with your stock. So your $200,000 now becomes $100,000. And you have to remember that you owe $100,000 of margin debts that you borrowed. So now your account value is zero. And because your account value is zero, you no longer have collateral. So you know what's going to happen next, your brokerage will margin call you and then they're legally going to sell your stocks without your permission to recoup the money that they lent you. And again, you got wiped out by a 50% stock market crash. And then what's going to happen? Like I said, the Federal Reserve will most likely come to the rescue by printing trillions of dollars and the stock market is going to surge higher. And then you, with your zero dollars in your brokerage accounts, will not get to enjoy and benefit from the recovery. Because again, you got wiped out in the crash because of your margin debts. And then all of your coworkers and friends and family will be like, Oh, my stock market account is up so much. And then imagine how you're going to feel. My assumption is that you're probably going to feel terrible. So that's why I stress and emphasize to my financial community, please be careful with margin debts. Because it can wipe you out or severely cripple you financially. And then you're going to be handicapped for the recovery. And I just want to extend my invitation to you to join my financial community on Patreon. And I just want to say that it's a good place for rational long-term investors that are not looking to get rich quickly. So you can sign up for free, receive our free content on the stock market and the economy. 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