Four Hidden Risks of Margin Debt

I was stunned to hear about the latest figures on the amount of margin debt carried by U.S. investors. For New York Stock Exchange shares alone, the figure hit a record $285.6 billion in January.

To put that in perspective, the previous peak, occurring at the March 2000 market top, was $278.5 billion.

Even more sobering is thinking that that's almost $1,000 in debt for every man, woman and child in the U.S. We're used to hearing figures like that for the national debt, not margin debt. (Don't worry, the national debt is still larger -- roughly some $27,000 per U.S. citizen.)

What's going on? More investors are leveraging with borrowed funds to chase stock-market returns. They're taking on more risk. It scares me in the big picture because we're all exposed to greater turbulence if the market goes into reverse.

But it also scares me when I consider the individual investor and readers of The Millionaire Zone. Margin borrowing is risky, probably more risky than any other kind of borrowing I can think of. And it isn't cheap, either. Most brokerages today charge rates ranging from 9% to 11% and higher (which, in some cases, may be deductible against investment income).

Most investors know that margin trading increases market risk. You're effectively pledging shares as collateral. Since share prices can be volatile, your equity position can rapidly change for the worse.

Safeguards known as minimum maintenance requirements trigger margin calls -- demands for equity infusions -- if equity drops below 30% of the portfolio value. Major exchanges require a minimum maintenance requirement of 25%, but most brokers have set the bar at 30%. Brokers also have different rules, some mandated by the Federal Reserve or the National Association of Securities Dealers, for stocks below $10, short sales, especially-risky stocks, "pattern" day traders and other specialized situations.

I'm not going to review all the rules of margin trading; most brokers, including E*Trade, cover it pretty well on their Web sites.

Click here for the video version of this story from Jennifer Openshaw.