Friday, February 29, 2008

Investing in the Stock Market with Leverage

Leverage is an investing technique that allows you to use a small amount of your own money with hopes that your investment will increase in value. When you use leverage to buy stocks, you are borrowing money so you can buy more shares then you normally could have afforded. Using leverage to buy stock is called buying on margin. If the stock price goes up, all is well. However, if the stock price goes down, the stock you bought is used as collateral and you could be forced to sell your shares. This is something known as a margin call.

I invested on margin once and only once. In the middle of the dot com bubble, my investments were flying high and I was feeling confident because I owned stocks like Cisco, EMC, Sun Microsystems, and Oracle. I felt compelled to make the most of the rising stock market and I wanted to own more shares than I could afford. I purchased shares on margin and I was highly leveraged.

On August 31, 1998 the Nasdaq dropped 8.6%. Many market observers were predicting another market crash similar to the crash of October 19, 1987 called “Black Monday” when the Dow lost 22.6% of it’s value. The decline on that August day was a scary moment for me because I received a margin call. If the market didn’t recover quickly, I would be forced to sell my shares for a loss. I recall feeling sick and lonely that day and I prepared myself for the worst. Fortunately for me, the Nasdaq quickly recovered and rose 5% the following day and gained back all its losses over the next five trading days. It was an amazing recovery and I was fortunate. That was the last time I invested in the stock market using leverage.

Tomorrow I will discuss using leverage to buy real estate.


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