When buying stocks on margin, you’re essentially borrowing money from your broker to buy securities.

Understandably, the main cost involved in buying stocks that way is the interest you pay. Plus, when you sell a security that you’ve bought on margin, you must first pay back the loan from your broker.

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The low interest rates of late 2016 add to the appeal of buying stocks on margin. But here are a few things to keep in mind if you’re considering this approach:

1. Increased leverage magnifies your profits—and your losses: The main risk of buying stocks on margin is that it increases your leverage. Leverage works two ways: It magnifies your profits when the market moves in your favour, but it magnifies your losses just as effectively when the market moves against you. That’s because the amount you owe on your investment loan stays the same, so every dollar your portfolio loses comes out of your equity.
2. Diversification and investment quality are especially important when buying stocks on margin. If you could buy on margin when the market hits bottom, stay margined as the market rises, and sell out at the peak, you could very quickly build a large fortune. But no one has the sense of superhuman timing necessary to consistently succeed in that. That’s why we continue to recommend that if you are going to use margin to invest, it’s all the more important to stick with our three-part investment program: mainly invest in well-established companies; spread your money out across most if not all the five main economic sectors; and avoid stocks that are in the broker/media limelight. If you rigorously follow that advice, you stand to make money over long periods. With margin, you’ll make even more.
3. Buying stocks on margin can help you cut your tax bill. That’s because you’ll be able to write off your margin interest in full against ordinary income in the current year. However, you’ll pay less than ordinary income-tax rates on dividends from Canadian stocks. If you buy qualified Canadian stocks, you’ll pay taxes on dividends you receive at a rate that is below the rate you pay on ordinary income. This tax break alone—getting a full deduction on your interest costs, and paying a lower tax rate on dividend income—adds appeal to margin investing. Of course, you have to go at it the right way, and make sure it suits your circumstances. (Note: We are not tax specialists. You need to confirm with your personal tax advisor that this treatment applies to your situation.)

3 ways to tell if you should be buying stocks on margin

Due to its increased risk, buying stocks on margin is certainly not for everyone. That’s why buying stocks on margin only makes sense if all 3 of the following apply:

1. you are in the top tax bracket and expect to stay in it for the foreseeable future;
2. you follow our conservative three-part investing approach (see above);
3. you invest consistently over a number of years, and resist the temptation to increase your margin borrowing when stocks have risen, or reduce it when prices have dropped.

Margin buying and market risk

The trouble with margin investing is that there is no consistent way to tell if the market will go up or not. And, when you’re buying stocks on margin, the two classic investing emotions—fear and greed—may play an even more exaggerated role in an investor’s market outlook.

It’s a well-known phenomenon that a rise in margin buying by individuals tends to be associated with rising market risk. Some technical market analysts use margin buying as a key market indicator.

We’ve never met a successful investor who uses margin buying (or any other market indicator) as a guide to investing. But we have met a number of successful investors who thought about buying on margin for a number of months or years, and who began buying on margin just prior to a market plateau or downturn. Some of these investors decided to close out their margin investing activities, at a loss, when the market was close to a low.

That’s why it pays to be aware of the underlying principles of this and other sentiment-based market indicators. They can help you temper your enthusiasm and control your fears, rather than going to extremes.

Have you had success with buying stocks on margin? What were some of your best timed trades? Share your stories and experiences with us in the comments.

This article was last updated on July 24, 2016.