A great way to invest is to make regular investments. Million Dollar Journey recently outlined 4 ways to invest small amounts of money each month, all of which are solid and worth considering. I agree with his 1% rule (the trading commission should never exceed 1% of the value of the trade), which can make it difficult to execute trades even with low cost brokers for people starting out with investing.
One idea to get around this is to use margin. Let’s assume that we are using a brokerage that charges $4.95 / trade and that we have $150 / month to invest. Let’s also assume that we’re aware of the risks of buying on margin and we want to keep our account, at most, at 10% on margin (a margin call occurs when your account exceeds 70% on margin). To keep things simple, we’ll ignore changes in stock value, dividends, interest (paid or collected) and brokerage fees.
Using the 1% rule, as long as we buy at least $495 of stock we’ll keep our transactions costs at or below 1%. After 4 months we’ll have saved $600 and can make our first purchase.
Now say, instead, that after THREE months we transfer over the $450 to our brokerage account, then buy $495 worth of stock (perhaps a nice, highly-diversified ETF). This would put us $45 on margin, or 10% (45/450) of our account.
Month | Bank Account | Stock | Margin debt |
January | $150 | $0 | $0 |
February | $300 | $0 | $0 |
March | $0 | $495 | $45 |
Next month we transfer $45 to pay off the margin loan, then start accumulating money to buy again. After we have $405 we can afford another purchase (since we can now go up to $90 on margin and stay under our 10% rules).
Month | Bank Account | Stock | Margin debt |
April | $105 | $495 | $0 |
May | $255 | $495 | $0 |
June | $0 | $990 | $90 |
Eventually (in this scenario in the 3rd year of investing) we’ll get to the point where we can just keep paying off the margin debt, and every time it is paid off, purchase 10% more of our portfolio worth. This lets us put money into our portfolio every month at no cost, slowly lowers our transaction costs as a percentage of purchase (since 10% of the portfolio SHOULD be an ever increasing amount) and take advantage of dollar cost averaging. We own the stock we want sooner, and can get a tax deduction for the interest paid on the margin debt (and avoid paying a higher tax rate on the interest we would have earned if we saved up to make purchases in a high-interest savings account).
There is also the added benefit that if we ever can’t make our monthly payment, it’s not a big deal (since the margin debt will always be conservative compared to the size of the portfolio). Conversely, if we have a windfall, it can be immediately applied to wipe out the margin debt (or add to the portfolio and increase the margin amount).
The dangers of this approach are quite slim, as our portfolio would have to drop by over 80% before we were in any danger of a margin call (which would be unlikely to happen in a month or two unless we were investing in VERY volatile equities).
I don’t do this and I don’t necessarily advocated others do it, but if people want to minimize their fees, while being able to add small, regular amounts to a stock portfolio I think this would be a reasonable way to do so. Another approach is Mike’s ETF vs. Index Fund strategy (which involves simple, regular investments in index funds until a set amount is reached, depending on fees and MERs, at which point the funds are sold and ETFs are bought with the proceeds – very similar to MDJ’s idea #4).
Do you make monthly contributions to an investment account? How do you do so to minimize fees?
17 replies on “Using Margin to Lower Trading Costs”
Personally, I think if someone doesn’t invest enough each month to keep within the 1% rule then they should:
1) Make sure their trading costs are as low as possible.
2) Just save up until they have enough.
The margin idea is a good one, especially if you think there is a temporary buying opportunity.
Thanks for the mention and great idea about using margin to reduce fees Mr. Cheap!
Very interesting strategy Mr. Cheap, I have never thought of that.
I don’t like that $4.95 assumption because basically the only Canadian broker to offer it for smaller-balance customers is Questrade… and the reviews for Questrade scare the crap out of me to the extent that I won’t consider them until they clean up their act.
Anyways, I’m with Credential Direct ($19/trade) and I also have a TD eFunds account. So my 1% threshold is $1900. I bought four ETFs for my portfolio; whenever distributions come in or whenever I invest new money ($100 twice a month on payday), I buy eFunds in whichever asset is the most below allocation. I’ll move over to an ETF above the $2000 threshold; but it’s not incredibly urgent because the fee differential is so small over the course of one or two years.
Mike: Yeah, minimizing costs and saving up is definitely the most straightforward approach.
Charles: I pay a $19.99 commission so I definitely hear where you’re coming from. As you say, the commission just changes the threshold. So for you, you’d save up until you had a little over $1700 than do the same thing. There would definitely be longer stretches of capital accumulation before you can make a purchase (although it would be shorter periods than if you weren’t using margin and just saving up to buy $1900 worth outright).
Saving up in eFunds is a great way to work up to this point (definitely check out Mike’s posts on the subject if you haven’t already read them).
@Mr. Cheap: Let me add – I did dip (very) slightly into margin when I bought my ETF shares for a different reason – because I can’t get an auto-DRIP at Credential. So I calculated the amount I expected to receive in dividends until my next rebalancing, and bought that much more than the cash I had available. The dividends were “close enough” my estimates and everything worked out.
Also it turns out that at Credential, if my margin interest would be less than roughly $5 a month, they don’t even bother to charge it. Although they wouldn’t give me an exact figure of course 😉
Love the strategy. Never heard of it before, but that doesn’t say a lot… I don’t do a ton of investing like that. I just put money away monthly into an IRA that follows the S&P 500. Simple as that.
Great post.
This strategy is similar to one I posted in MDJ’s comments regarding saving money, but I just suggested using a regular line of credit. i agree margin trading makes better sense.
However, you used the phrase “dollar cost averaging” in your post, and DON’T think this IS dollar cost averaging.
As I understand it, DCA involves investing a constant amount regularly over time. It has two advantages- it allows you to pay small amounts off your paychque so you don’t notice the loss, and *it reduces volatility, because the price you pay for the investment will be approximately the average cost of the investment over the period you’re making the purchases*. I think that’s where the word “averaging” comes in. In other words, if you buy $12, 000 of a stock today, you take the risk that the stock is high today. If you invest that $12,000 over the course of a year (say $1,000/month), then you will end up getting shares at more or less their average share price over the course of the year. On the other hand, you don’t get the chance to spend the $12,000 on a day when the share is down.
The margin strategy involves buying the shares all at once (if I understand it correctly), in order to reduce fees. It therefore doesn’t have the second Averaging benefit of dollar cost averaging.
Thomas: Thanks for the comment. Sorry if this is similar to something that you posted about (I didn’t read your comment, so its a coincidence – I’ll go check it out now).
In my opinion this *is* dollar cost averaging, because you’re contributing the $150 each month, and you’re buying regularly (maybe not monthly, but multiple times a year in the early stages, depending on your broker’s commission and whatnot). It isn’t a “buy all at once” approach.
Thomas: Yes, you’re right, quite a similar idea. Interesting link to the Rempel Maximum.
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Not a bad idea. Since I plan to invest soon through a Smith Manoeuvre, the double leveraging might be more than I’m comfortable with.
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The problem with using margin is that it is essentially a loan, and you have to pay interest on the amount that you borrow
John: Yes, you’re absolutely right. I ignored this in the post for clarity’s sake (along with dividend income and stock appreciation).
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