From time to time, leverage can be a valuable device for profiting from short-term moves in the market. But most investors, particularly those with less capital and those who pay little attention to their portfolios each day, are advised to avoid leverage altogether. Leverage involves borrowing against assets in order to buy additional assets. An investor who places $10,000 with a brokerage firm to purchase $20,000 worth of stock is leveraging his assets. The brokerage firm acts as a bank, lending the investor the additional $10,000 of stock, charging interest on the balance.
A good rule of thumb for most people, who apply leverage to their stock positions, is to make sure to pay less in interest on that margin than the cash income they are making on the assets themselves. In other words, limit the margin to available cash flow, or the capital may evaporate. The Federal Reserve regularly reviews the margins allowable in the stock market and it has stood at 50 percent for some time. I suggest that investors borrow less than the maximum allowable; in a bad market, higher leverage can prompt forced selling to meet margin requirements. Another rule of thumb that I use for margin is to plan to be out of margin at least once each year. This premeditated plan serves me well by forcing me to keep thinking about that margin. If an investor adheres to a fixed margin reduction schedule and is confident that his assets will produce more income than the cost of that margin, he should forge ahead and utilize leverage prudently. It is a tool to enhance performance, particularly for short-term moves.