3 Rules For Using Margin Safely And Profitably (2024)

Note that due to reader requests, I've decided to break up my weekly "Best Dividend Stocks To Buy This Week" series into two parts.

One will be the weekly watchlist article (with the best ideas for new money at any given time). The other will be the update on the Deep Value Dividend Growth Portfolio (which is beating the market by 10.7% so far and across all time frames).

To also make those more digestible, I'm breaking out the intro for the weekly series into a revised introduction and reference article on the right and wrong way to use margin (which will no longer be included in those future articles ).

My Personal Margin Update

As I explained in my portfolio update 63, I'm now focused on paying down margin and thus won't be buying stocks in my real money portfolio for the foreseeable future.

However, I did recently sell three high-risk stocks since I've decided to follow a more DVDGP style (low-risk) approach. Those sales included Uniti Group (UNIT) and Omega Healthcare (OHI), both at a large profit. Given that Uniti then plunged post the Windstream (WIN) trial loss Friday (-30% AH) I got very lucky with that one.

I sold Clearway Energy (CWEN) because it became high-risk when Guggenheim warned that, after talking with management about the PG&E (PCG) bankruptcy fallout, the analyst firm believed a major dividend cut was imminent.

I've been closely following the PCG Ch 11 sage since CWEN has 23% of revenue under long-term contracts with PG&E. The analyst warning was enough to boost my estimate of a dividend cut from 25% to over 50% and thus trigger my sale a day before the yieldCo slashed its payout by 40%.

I also sold CWEN in DVDGP (a 1% position, at an insignificant loss) and rolled that money into AbbVie (ABBV) which was our biggest loser at the time (to lower the cost basis). Thus, not only did I manage to exit CWEN before the thesis broke (always the goal for income growth investors), I also managed to, in combination with the UNIT and OHI sales, reduce my portfolio margin by $22K down to $84K. That's down from a peak of $139K in late November and means my leverage is down from a peak of 85% (on December 24th) to 38% today (I'm a 63% portfolio decline from a margin call). I have no further asset sales planned unless a thesis breaks on one of my stocks.

At my current savings rate, it will take me 9 to 11 months for my weekly savings and net dividends to take my margin down to zero (so by the end of the year). At which point I plan to follow the long-term strategy outlined in this article (or at least a revised form of it depending on how economic conditions look at the time).

But while I don't plan to personally use margin in the future, plenty of investors have proven that with the right approach and disciplined adherence to three critical rules, you can indeed use margin safety and profitably.

3 Critical Rules For Safely And Profitably Using Margin

Warren Buffett is famous for his warnings against using margin.

My partner Charlie says there is only three ways a smart person can go broke: liquor, ladies and leverage...Now the truth is - the first two he just added because they started with L - it's leverage... It is crazy in my view to borrow money on securities... It's insane to risk what you have and need for something you don't really need... You will not be way happier if you double your net worth." - Warren Buffett (emphasis added)

Now, as with all Buffettisms, this one needs clarification. Margin is not necessarily evil, it's merely a powerful financial tool that must be used with extreme caution.

As many people know Buffett actually uses leverage himself, and a great deal of it. A famous study ("Buffett's Alpha") found that a critical component of Buffett's ability to achieve over 50 years of 20+% CAGR total returns was his use of insurance float as leverage. The study concluded that Berkshire's (BRK.B) leverage averaged about 1.7 over time.

But does this mean that Buffett is a liar and a charlatan and that investors should be willing to leverage their portfolios at similar rates? Absolutely not!

The first principle to smart margin use is to use non-callable and low-interest loans. Technically insurance float is callable, because should enough disasters strike at once Berkshire might have to pay out massive amounts of money that could theoretically put it in financial trouble.

However, Buffett has a rule that BRK will always maintain at least $20 billion in cash as an emergency reserve in case of such a scenario. In addition, BRK's various subsidiaries have revolving lines of credit that can be called upon in case $20 billion isn't enough (not to mention the rest of the giant cash pile).

Most importantly, Berkshire is one of the most skilled risk managers in the world, which is why historically it achieves a 5% profit on insurance underwriting. Or to put another way, Buffett's "margin" has an effective interest rate of -5%.

In the hands of the greatest value investor in history (and the most disciplined) -5% margin has been put to masterful effect and made Berkshire investors rich over time.

But unfortunately most of us don't run giant and highly profitable insurance companies so how can regular investors use margin like Buffett (or at least follow his example)?

That would be using non-callable loans like a low-cost home equity line of credit. Mind you I'm not saying that it's a good idea to tap all the equity in your home (and thus risk your home in case disaster strikes).

But say your mortgage is paid off, and your home is worth $300K. In that case, borrowing 10% to 20% of that value ($30K to $60K) might make sense if you have a stable income high enough to make the monthly payments. Not all the time of course, but if we're in a bear market or severe correction, and you use that money to buy quality, low-risk dividend stocks with an average yield above the interest rate, then this approach is a low-risk way to use leverage. And the dividends covering the interest costs means that the companies will be paying you to buy them at rock bottom prices (with high future total return potential).

Several readers have told me they used just this strategy during the Great Recession and wound up making a fortune. But of course, the reason they were able to do so as they had the financial discipline to obtain such a non-callable low-interest loan in the first place.

If you're drowning in debt because you can't live below your means, then such a strategy is impossible, both because your credit rating will be too low for such a loan, and you probably don't have much equity in your home.

One other alternative you can use for non-callable loans if you don't own a home but have great credit is something like Goldman Sachs' (GS) Marcus.

(Source: Goldman Sachs)

If you have excellent credit (FICO over 800) then you can obtain a personal loan from Marcus for up to $40,000 at 6% interest that you can pay off over six years. That comes to a monthly payment of $663. Of course, if you have worse credit then your interest rate might be as high as 29% and the maximum term just three years (meaning a monthly payment of $1,698).

The key with optimal use of leverage is to make sure it's a non-callable and self-amortizing loan. For example, if you have a high enough and stable enough income to support $663 per month (likely lower in a recession when the Fed Fund rate will go to zero) payment, then make sure you only buy low-risk blue-chips with a yield of 6% or more. During a bear market, plenty of REITs MLPs and even regular c-Corps will offer that.

Thus the safe and exponentially growing dividends will pay the interest (and hopefully more) allowing you to acquire deeply undervalued income producing assets that will significantly increase in value over time. And as long as that dividend stream (or your income) is making the monthly payment, there is never a risk of a margin call that can force you to become a forced seller.

But you'll notice how the above strategy, which allows regular investors to come as close to Buffett in the use of margin, only works at certain times (like a bear market) and for certain people (those with great credit and supreme financial discipline).

What if that doesn't describe you? Well, that brings me to the second critical rule of safe margin use.

2. For Most Investors Not Using Margin At All Is The Right Approach...

I know several investors who cap their leverage at 20% or less or maintain home equity lines of credit that can be used to pay down 100% of margin quickly in a market meltdown. These people are the exception and not the rule.

The reason that Buffett is warning the average investor against leverage is that it amplifies both financial gains/losses but also emotions.

Since emotions are the Achilles' heel of most investors and results in terrible market timing that badly hurts long-term returns, for the vast majority of investors, margin is a tool that's best avoided.

This is why I'm personally not planning to margin in the future. The worst December for stocks since 1931 has shown me that it's not enough to minimize the risk of being wiped out (via a margin call). The risk of a total loss of capital must be zero. After all, even if the odds of losing 100% of your money is 1/1000, eventually, you'll still get wiped out. Thus, even decades of painstaking saving and smart investing could be lost, which is indeed insane.

Because while I'm unlikely to face disaster this time the core of my investing strategy stems from being able to "be greedy when others are fearful" and take advantage of the market becoming insanely stupid and provide quality companies at obscene discounts to fair value.

You're neither right nor wrong because other people (the market) agree with you. You're right because your facts are right and your reasoning is right - that's the only thing that makes you right. And if your facts and reasoning are right, you don't have to worry about anybody else."- Warren Buffett (emphasis added)

With margin, you absolutely have to worry about other people. If our leaders (specifically Trump, Congress or Fed Chairman Jerome Powell) mess up badly enough, the economy and the stock market (SPY) (DIA) (QQQ) could be sent spiraling into a crash that could make even the smartest long-term strategy fail catastrophically.

In other words, to paraphrase Einstein,

there are two things that are infinite, the universe and short-term market stupidity, and I'm not quite sure about the universe."

On October 19, 1987 (Black Monday), the Dow fell 22.6% in a single day. That's a 20 standard deviation event that is theoretically (using standard probability theory) supposed to occur once every 4.6 billion years (roughly the age of the earth).

However, according to a 2005 Harvard study, a 1987-style one-day crash is actually a once in a 104-year event.

(Source: Market Watch)

What's more, 5% and 10% single-day crashes are expected to occur, on average, every 1.6 years and 13 years, respectively. And as Mark Hulbert, author the Hulbert Financial Digest, points out, the last 5% single-day decline was in August 2011, and the last 10% daily decline was over 30 years ago.

So, not just are we overdue for some even wilder single-day declines, but we can't forget how margin actually works at most brokers. Brokers borrow at very short-term rates to extend margin loans to clients. In the event of another 2008-2009 style financial crisis (a low probability but inevitable event over 50+ years), the brokers could change their margin rules overnight. That's because most margin agreements state that:

• Brokers can change their margin maintenance requirements at any time (potentially from 15% to 50% or higher).
• Brokers are able to liquidate your stocks to eliminate margin even without notifying you or providing time to send in additional funds.

While brokers normally provide two to five days to cover a margin call, in the event of either a seizing up of credit markets (that could put the broker's survival in jeopardy) or a full-blown market panic (like 1987), even modest amounts of margin could become dangerous and trigger forced selling at ludicrously low valuations of even the highest quality, low-risk stocks.

Since my time horizon is 50+ years, I must not just minimize my portfolio's risk of succumbing to a critical point of failure by eliminating all such risks of a permanent loss of capital (across the entire portfolio).

It's also why I advise anyone interested in using margin to use non-callable loans if you qualify for them. If you don't then your financial discipline is likely too poor to even consider using this powerful but potentially dangerous financial tool.

But what if you just want to use regular broker margin? Well, then there is one final rule to follow if you want to make money in the long-run.

3. Use Margin Sparingly, With Discipline AND Only In A Counter Cyclical Fashion

Smart margin use is simple in theory. You're trying to recreate the banking business model of borrowing at low-interest short-term rates, then investing in long-term appreciating assets that will make you a profit.

But to actually pull this off requires far more discipline (and low margin rates) then most people have.

(Source: Interactive Brokers)

For one thing, most brokers charge sky-high margins rates even for those who borrow immense quantities. If you're with E-Trade that 10.5% margin rate means that it almost never makes sense to use margin no matter how good the bargains are. High margins rates are the purview of the short-term trader, not the long-term investor.

Interactive Brokers (IBKR) (my broker) charges a sliding scale based on how much you borrow that's tied to the Fed Funds rate. Its standard margin rate is 1.5% + FFR for amounts under $100K meaning 3.9% today (and 1.625% in March 2009). For amounts over $3 million, the rate is 0.25% + FFR or as low as 0.375% in March 2009 (when the FFR was zero).

But even if you're using IBKR as your broker don't forget that the higher the market climbs the lower the expected future return is. That makes it harder to use margin wisely.

(Sources: JPMorgan Asset Management, FINRA)

That's especially true if you use margin like most people, which is ramping up leverage as your portfolio appreciates and you have access to more buying power. As you can see at market peaks margin is higher than it is at market bottoms.

That's largely due to margin calls forcing overleveraged investors to sell (at huge losses) but also because everyone wants a bargain until the stock market actually offers it. In other words, times of peak fear and maximum future returns are precisely when people have the least appetite for owning stocks and using margin even though that's precisely the smartest time to use it.

That's especially true when you consider how much your portfolio needs to decline to get a margin call (and become a forced seller).

Distance To Margin Account By Leverage And Account Type

(Sources: FINRA, Interactive Brokers

Most margin users are on Reg-T meaning their brokers require 25% margin maintenance. Some brokers allow Portfolio margin (15% maintenance requirement) and IBKR has an 8% requirement for portfolio margin accounts that are invested in non-leveraged and standard ETFs (like SPY or SCHD).

The above table shows how far your portfolio needs to decline to get a margin call depending on how leveraged you are. A modest 10% to 20% leverage rate is not dangerous for most people, even factoring in that maintenance requirement can rise during times of peak volatility. But take your leverage up to 50% or more? And then suddenly you can see why it's not wise to be highly leveraged, especially if you're margin is peaking at the top of a bull market and you're mostly using margin to buy high volatility momentum stocks (like FAANG).

On the other hand, during a bear market, say when stocks have fallen 30% from their all-time high and valuations are dirt cheap? Well, that might be a good opportunity for disciplined investors to deploy modest amounts of margin into low-risk quality dividend growth stocks, especially if the yield is above the margin cost and the companies are literally paying you to buy them at fire-sale prices.

Why 30%? Because since 1929 that's what the average peak decline of the S&P 500 (including the epic crashes of the Great Depression) was at the bear market bottom.

Of course, averages are a very rough guide and not a prediction of what will happen during any particular bear market. That's why it's wise to use margin sparingly in case 30% isn't the bottom and stocks go on to fall another 10% to 30%, or even more should doomsday prophets like John Hussman (60% to 70% market crashes predicted annually since 2010) finally be proven right.

Bottom Line: Like Any Powerful Tool Margin Isn't Evil, But Must Be Used With Immense Caution, Discipline And In Extreme Moderation

Let me be very clear, margin isn't for most people, only the select few with the financial discipline and strong credit to use it wisely and safely. Ideally, if you use margin at all (99% of investors are better off not) your first choice should be a low-interest non-callable loan like a home equity line of credit or a personal loan that you will have no trouble servicing.

Even then you should be cautious and only buy during times of extremely low valuations (like bear markets) and only low-risk dividend growth stocks whose yields are high enough to fully cover your interest payments.

If you want to use regular broker margin don't forget those loans can theoretically be called at any time, potentially forcing you to become a forced seller at the exact wrong time. So if you choose that route, make sure to use a very modest amount of margin (like 10% to 20% of the value of your portfolio).

And even then make sure you're doing so at the right time, and using the leverage counter-cyclically, and in low-risk stocks, preferably with yields high enough to pay off the loan over time (self-amortizing debt).

But ultimately the right way for most investors to use margin is to follow Buffett's advice and not use it at all. Leverage magnifies not just financial gains and losses but emotions as well. Unless you have the experience and supreme discipline to use margin the right way (as Buffett has been for decades) this powerful financial tool isn't right for you and could potentially destroy your long-term financial dreams.

Dividend Sensei

Dividend Sensei (Adam Galas) is an Army veteran and stock analyst with 20+ years of market experience.

He is a founding author of the investing group The Dividend Kings which focuses on helping investors safeguard and grow their money in all market conditions through the highest-quality dividend investments. Dividend Sensei and the team of analysts (Brad Thomas, Justin Law, Nicholas Ward, Chuck Carnevale, and Sebastian Wolf) help members invest more intelligently in dividend stocks. Features include: 13 model portfolios, buy ideas, company research reports, and a thriving chat community for readers looking to learn how to invest more intelligently in dividend stocks. Learn more.