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Should You Borrow Money to Invest in Stocks?

NEW YORK ( TheStreet) -- Margin took some real knocks this week from the press, most of whom, until this week, thought margin was that thing on the left hand side of a piece of lined paper. So now that we have seen and heard of the underside of margin from just about everybody, why do we allow it at all?

Margin, of course, is just another form of credit. The notion of borrowing money, per se, is not a bad one. People borrow money when they don't currently have the money on hand they need to make a sizable purchase but the purchase is necessary.

That's how I prefer to use margin at my company. I use it judiciously, a couple of times a year when I need capital to make a sizable bet. Sometimes we think that stocks get so cheap that we are willing to lever up. In 1991, when I was trading with my wife, we made a huge margin bet.

At the time, the U.S. was about to launch the Gulf War. The press was filled with all sorts of stories about the much-vaunted Iraqi Republican Guard, elite troops that could cause real problems for our military. A close reading of the papers at the time would have made you believe that Iraq's army could equal the United States' Army.

OK, I am a military history buff, always have been. I have studied the great traditions of our military, and have spent a lot of time analyzing its ability to project power when it has to.

The day before the Gulf War began my wife, Karen, my trading partner, said " How long is this war going to last, and how bad will it be?" I told her we would win in a heartbeat and the only question was whether we would occupy Baghdad or not. I told her it was a walk and it would be clear to everyone from the moment it started. She wanted to know how confident I was about this. I said I would bet the farm on it. Everybody in the press was just too darned negative about the U.S. military.

At the time a vicious bear market had ruled over equities since the Kuwait invasion. It had shown no signs of relenting other than a possible bottom in the financials in the months leading up the New Year. My wife and I had played it lean. We had a great year relative to the market in 1990, finishing up nicely, which had given us three years of much better than market performance.

It was time to do something risky.

My wife asked me for my 10 best stocks. I gave them to her. With the war deadline hours away she bought hundreds of thousands of shares of each, making sure that we had spent every penny we had and then some.

She said, "It is time to be fully margined." By the end of the day we had gone to the limit of what we were allowed to borrow. The next day the war began, the markets roared. Ten days later it was pretty much over. She took everything off the table during those 10 days and then took off from work for the rest of the quarter. We had made that much money.

Reckless? A tad. But it was one of those classic instances where we wanted to press the bet. We were off margin by the end of the war. We didn't use it again that year.

Periodically we use it if we think we have a sense of something that no one else has or when people have gotten too negative or when there is something that we see that others don't. But we are always off it very fast. We know its addictive qualities and we don't want to go there.

People who use margin routinely are betting that markets will go up constantly. I think that's a stupid bet. People who don't know how to do anything but be on margin are, in my eyes, no different from people who don't know how to kick the credit-card habit. They are going to be perpetually behind in a bad tape and one can never presume that we are immune to a bad tape.

So why is it so easy to obtain? Why aren't we more strict with margin? Simple. It is a very lucrative business. Brokerage firms make their real money off of margin. The commissions aren't big enough. But the borrowing gig is. It is a great businesses for the brokerages because they have the collateral in their accounts and they can sell it out from underneath you without your say. That's not easy for a bank to do, say, to your home mortgage.

If you can make loans to borrowers and know that you can get your money back in the form of claimed equity that you have access to, you want to loan as much as possible.

So, use margin judiciously. Use it when you have an edge for a short time. Don't make it a practice and you will not be wiped out by it.

I always say that the goal of investing is to "stay in the game." Never let yourself get blown out. Margin can blow you out. As long as you remember that, you will do fine with it.

James J. Cramer is manager of a hedge fund and co-founder of TheStreet.com. At time of publication, his fund had no positions in any stocks mentioned. His fund often buys and sells securities that are the subject of his columns, both before and after the columns are published, and the positions that his fund takes may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Cramer's writings provide insights into the dynamics of money management and are not a solicitation for transactions. While he cannot provide investment advice or recommendations, he invites you to comment on his column at jjcletters@thestreet.com.

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