NOTE: This is a work in progress, I will continue to update this article over the coming week.

Fire in a wonderful element. It dramatically improved the quality of human life, yet it has also wreaked great havoc and considerable personal pain. Investing on margin is similarly a double edged sword. Margin can significantly improve the performance of your portfolio, but it can also wreak havoc and evaporate your funds faster than most people imagine.
Look around at the current financial meltdown. At the root of it is margin. Margin is a synonym for mortgage. At the height of the residential property market, individuals were employing 100% margin to buy over valued assets; houses, condos etc. The lending banks were employing even more ludicrous levels of margin, over 1200% margin in most cases. It was clearly a house of cards.

My Ten Rules of Margin Investing

As I wrote back in September you should only consider using margin at significant market bottoms . That is Rule 1.

Rule 2. Make sure your financial house is in order and you understand your finances before considering margin.

• All debt is bad, but some debt is slightly less bad. Very roughly the order of debt from worst to not so bad is; consumer debt, personal debt, mortgage debt, tax deductible debt. If you’re thinking of investing on margin then I seriously hope you have no consumer or personal debt. If you do, pay that off first.
  In a future article I’ll discuss why you should consider exchanging all your non-deductible debt, like a mortgage on your home, for tax deductible debt. In short it is your investments that should employ margin instead of having mortgage debt. The trick is how to do this safely.

Rule 3. The devil is in the details. You must know the all the details of margin investing before you start. This investopedia series is an excellent primer. In particular you must understand the dreaded margin call.

Rule 4. Ensure you never get a margin call. While totally removing all risk is impossible it is possible to get close to removing all the risk. I will go into details on how to do this in a later article, or skip to the bottom for a quick summary.

Rule 5. Do you really need to use margin? Like the dark side the lure of margin is strong, but do you REALLY need to use margin to meet your financial objectives?

Rule 6. Is there a safer way of achieving your desired leverage without using margin?

Rule 7. Calculate how much you could loose. Remember you are not only risking your capital you are also on the hook for the entire margin loan. To help you calculate the downside you may want to read some worst case commentary like this Thomas Nogales e-letter. Markets can fall way further than most imagine. While long term holders can simply hold on, if you are on margin you don;t have this luxury.

Rule 8. Margin is a loan, so like any loan you want to get the best rate possible.

Rule 9. Avoid buying high risk assets on margin. While all asset carry some degree of risk, some assets carry substantially more. Banks for example, as outlined by Greg Hoffman article on Commonwealth Bank.  (Note: I ignore this rule as I manage a portfolio rather than buy particular assets on margin)

Rule 10. Don’t get addicted or dependent on margin. When fear is melted is by greed it is time to start weening yourself off margin.

Margin and Me

Reading the above makes me feel like a really bad parent, “don’t do this, don’t do that.” As today marked the end of two weeks of fund though exhausting school holidays, I guess that is not suprising.

Here is what a couple named Bill and Ben could do. Remember I am not, nor have I ever played the role of a financial advisor. We’re all unique and what works for Bill and Ben could be disastrous for you.
With shares on sale Bill and Ben are considering a margin loan.
Bill and Ben Assets

Bill and Ben do not get to claim interest on their mortgage as a tax deduction. Step one is to swap that bad debt for good debt. They should pay off their mortgage with their share market funds. Then using their house as collateral get a line of credit for $200,000 with which they should again buy $100,000 in their preferred share market fund. This can all be achieved without actually physically selling and re-buying any assets. Now Bill and Ben have exactly the same assets and liabilities, but they have moved their debt from non-deductible to deductible. Depending on their tax rate and interest rates this could be worth around $3000 annually in tax savings.

Other benefits.
In Australia a line of credit is 3-4% less interest a year.
There is no margin call on your line of credit.

Disadvantages.
If Bill and Ben are like most consumers with credit cards, the $400,000 line of credit could be a millstone around their necks. You must be fiscally super responsible to even consider this.
NOTE: As I said at the start this is a work in progress. Please contribute if you have any thoughts. All taxation based on Australian rules.

Related posts:

1. Random Ramblings on Margin, Market Timing and Investing Secrets
2. Margin Investing
3. Fusion Investing Announces First Purchase
4. Margin of Safety Seth Klarman