Investing On Margin (Beware The Double-Edged Sword!)

Investing on margin is similar to purchasing a home. Most home buyers borrow money to be able to purchase a larger home than they could afford if they had to pay cash for the entire purchase price. Investors that use margin borrow money to increase the amount of stocks they're able to buy.

The primary reason investors use margin is to increase their investment returns. Unfortunately, using margin can work against you just as easily as it can work in your favor.

Investing Without Margin

Let's start by looking at an investment made without the use of margin. Assume you purchase 100 shares of ABC Industries when it's trading at $50 per share. Your total investment would be $5,000 (100 shares x $50 per share = $5,000 investment).

Assume the stock price of ABC Industries climbs to $55 per share and you sell your total holdings for $5,500 (100 shares x $55 per share = $5,500 proceeds). This would give you a profit of $500 ($5,500 proceeds - $5,000 investment = $500 profit) which represents a 10% gain on your initial investment ($500 profit / $5,000 investment = 10% gain).

Using Margin To Magnify Gains

Now let's assume you used margin for your initial investment in ABC Industries. Assume you invest $2,500 of your own money and borrow $2,500 from your brokerage firm for the initial investment. You then purchase the same 100 shares for a total of $5,000 (100 shares x $50 per share = $5,000 investment).

You would still realize a profit of $500 if ABC Industries climbs to $55 per share and you sold your shares (100 shares x $55 per share = $5,500 proceeds - $5,000 initial investment = $500 profit). However, due to the fact that you only used $2,500 of your own money, that $500 profit now represents a 20% gain on your money ($500 profit / $2,500 investment = 20% gain).

In this scenario, borrowing 50% of the initial purchase amount doubled your gain from 10% to 20%! Of course in the real world you'd pay interest on the money you borrow and might pay trading commissions, but you'd still end up better for using margin in this scenario.

Stocks Don't Always Go Up 

Margin is a double-edged sword. Using margin is great when stocks go up, but even a small drop in price could be enough to wipe out your initial investment if you are using a lot of margin.

To illustrate this risk, assume you purchase 100 shares of ABC Industries on margin at $50 per shares as you did in example above, but this time the price of the stock declines. You would realize a -$500 loss if you sold your holdings when ABC Industries was at $45 per share (100 shares x $45 per share = $4,500 proceeds - $5,000 investment = -$500 loss).

You only invested $2,500 of your own money since you borrowed 50% of the initial investment using margin, but this loss now represents a 20% loss on your investment because you used margin (-$500 loss / $2,500 investment = -20% loss)! Investing on margin looks great when stocks go up, but it doesn't take much of a price decline to realize how dangerous using margin can be!

Some Of The Risks Associated With Buying On Margin

(1) Stocks don’t always go up – Using margin magnifies your losses when stocks decrease in value.

(2) You can lose more than you deposit – If the securities you purchase decline in value, you may be required to deposit additional funds to cover the losses. This is called a margin call.

(3) Your brokerage firm can force the sale of securities – If you are required to deposit cash to cover your losses, your brokerage firm has the right to sell securities in your account to meet the margin call if you don’t deposit money in time.

(4) You pay interest even if you lose money – Interest will be charged on your margin balance whether or not you make money on the trade, and paying interest to lose money just adds insult to injury!

Using margin as a way to increase returns is one of the biggest mistakes that investors make. Make sure you know what you're doing - and understand all of the risks involved - before using margin in your accounts.

To learn more about our company - and find out how we are different from other financial advisors - call (210) 587-6433 or visit www.VannoyAdvisoryGroup.com.

The Nifty, Thrifty Thrift Savings Plan (TSP)

The Thrift Savings Plan - or TSP for short - is a retirement plan designed for members of the uniformed services and Federal civilian employees. If you're eligible for the TSP, don't overlook it just because you have a pension! TSP contributions should be an integral part of your retirement planning.

How Your Money Is Invested

The TSP has five funds that invest in different types of stocks and bonds, as well as several "Lifecycle Funds" that invest in different combinations of the five individual funds based on various investment time horizons. Participants have complete control over the mix of funds they select for their accounts.

Available TSP Funds
C Fund - Large- and Mid-Sized US Stocks
S Fund - Small- and Mid-Sized US Stocks
I Fund - International Stocks
F Fund -  US Government, Corporate, and Mortgage-Backed Bonds
G Fund - US Government Securities
L Funds - Mix of C, S, I, F, and G Funds Based on Various Time Horizons

Contribution Limits and Taxation

Just like 401(k) and 403(b) plans, Servicemembers and Federal employees make contributions to individual TSP accounts. Some Federal employees receive matching contributions in addition to the amount they contribute. You can contribute up to $17,000 to your TSP in 2012, or $22,500 if you’re 50 or older. These amounts are separate from any matching contributions you receive. Servicemembers in combat zones are eligible to contribute up to $50,000.

Currently TSP contributions are tax-deductible when made and withdrawals are taxed in retirement. Beginning sometime in the next few months participants will have the option to make Roth-type TSP contributions that won’t be tax-deductible now but will provide tax-free withdrawals in retirement. Withdrawals of Roth-type TSP contributions can be a great way to balance out taxable pension benefits in retirement.

Fees and Expenses (Or: My Favorite Part of the TSP)
Mutual funds sold by brokers often charge up-front commissions of 5.75% or higher. In addition to sales charges, they often have very high ongoing expenses.  According to Morningstar, the average expense ratio of funds that invest in large US stocks is 1.45%. The expense ratios for small US stock funds and international stock funds are much higher, averaging 1.61% and 1.68% respectively.

There aren't any sales charges or commissions on TSP funds. In addition to avoiding those charges, you'll also pay some of the lowest expense ratios I've ever seen. According to the TSP website, the 2010 expenses of all of the funds were 0.025% or less! These low costs are one of the best reasons to invest in the TSP. The less you pay in investment costs, the more you keep for yourself!

What Happens When You Leave

Any money you contribute to the TSP is yours to keep. When a Servicemember separates from service, or a Federal worker leaves his or her job, they have the option to roll their money to an IRA or leave it in the TSP. There’s also the option of cashing it out, but that can lead to taxes and early withdrawal penalties if you’re under 59 ½.

My suggestion is to consider leaving your funds in the TSP when you separate from service or retire. It has all of the basic asset classes you need to build a diversified portfolio and some of the lowest costs around.

You can go to www.tsp.gov to learn more about the TSP and available investment options

To learn more about our company - and find out how we are different from other financial advisors - call (210) 587-6433 or visit www.VannoyAdvisoryGroup.com.

Financial Tips for New Graduates

Here are a few financial tips for recent - or soon to be - college grads.

Tip 1: Review your student loans.

The place to start when reviewing your loans is to find out when your payments start. Never miss a payment or pay late because doing so can wreck your credit. Next, check to make sure your loans have fixed interest rates. Try to consolidate any variable rate loans into a fixed rate loan to avoid a surprise rate increase in the future. Lastly, take advantage of special incentives offered by your lender such as a reduced interest rate for setting up automatic payments.

Tip 2: Start a cash reserve.

Start by setting aside whatever you can, even if you can’t reach the recommended goal of 3 to 6 months of living expenses right away. Just having a few hundred dollars saved to pay for emergency expenses can help you avoid building up debt that can haunt you for years. Check out www.bankrate.com to find fee-free places to stash your cash.

Tip 3: Take advantage of your retirement plan at work.

If your employer offers a 401(k), 403(b), or similar retirement plan, make sure you sign up as soon as you're eligible. This will help you get a head start on retirement, and most plans offer matching contributions that can help boost your savings. You should at least contribute enough to get the full match offered, if not more.

Tip 4: Shop around for auto insurance.

If you were on your parent’s auto insurance, don’t automatically stick with their company. Shop around and make sure you find the best deal for yourself. You can use www.insweb.com to speed up your comparison shopping.

Tip 5: Get renters insurance.

Renters insurance covers things like your electronics, furniture, clothes, and other items if they are stolen or damaged. It's inexpensive but many people never think of getting it. Going through the same company as your auto insurance can save you money.

Tip 6: Start setting financial goals.

It’s never too early to start setting financial goals. The earlier you start planning for goals like buying a home and retirement, the easier it will be to save enough money to accomplish them.

To learn more about our company - and find out how we are different from other financial advisors - call (210) 587-6433 or visit www.VannoyAdvisoryGroup.com.