When you're buying stock, what's the difference between a cash account and a margin account?
What's going on in stock investors? This is Dash and this is Mind Over Finance. By the
end of today's video, you'll clearly know the difference between buying stock using
a standard cash account and using a margin account. And please stick around until the
end, because I'm also going to tell you why I think margin accounts are a terrible idea
for most investors. To keep the YouTube algorithm god's happy, please don't forget to pull smash
that light button.
Let's talk cash accounts first, because they're really straightforward. When you buy common
stock, IE invest in companies on the stock market, more often than not, you're going
to do that through some type of online brokerage. That's TD Ameritrade, that's Fidelity, that's
E-Trade, that's Charles Schwab, even though Charles Schwab owns TD Ameritrade now. But
these online brokerages usually have some kind of platform to make it easy for you to
buy and sell stock. While it's usually free to open an account with an online brokerage,
when you're ready to start buying stocks, you usually fund this account with your own
money. And the cash you've put in is the money you have to buy and sell stocks with. No more,
no less. With the cash you have in that brokerage account, you can buy stocks, willy nilly,
sell foolishly if you want to, trade foolishly if you want to. You have that freedom. With
a cash account, if you make poor decisions and you lose everything, the most you stand
to lose is the money that you've put in.
Now let's talk margin accounts, a little more complicated, but I think I got this. Today,
instead of looking at the formal definition of a margin account, let's look at the definition
of the word margin, because in a moment, I think it's going to help us better illustrate
not only what a margin account is, but how it works. Hey Siri, what does margin mean?
As a noun, it means an amount by which a thing is won or falls short. Want to hear the next
one?
Sure.
As a verb, it means provide with an edge or border.
A margin account is an account where you use leverage to buy more stock. In other words,
you borrow money from your brokerage to buy stock. And you might be thinking why on earth
would anybody borrow money to buy stock?
I'm not the best artist in the world, but I think the best way to understand the difference
between cash accounts and margin accounts is to see it. I know it helped me out a lot.
So here are my lovely drawings, one for a cash account and one for a margin account.
And just to illustrate how they work, these aren't real numbers by the way, but let's
just say, for example you invest $1,000 in McDonald's. McDonald's sells more and more
golden fries, juicy hamburgers, and of course, strawberry milkshakes. So your $1,000 investment
grows to $2,000. So the $1,000 we've invested plus 1,000 more from the stock growing. So
everything in total amounts to $2,000. What we really have to pay attention to here is
what our return on investment would be. So if I've invested $1,000, this is all profit.
And then how do we come up with our return on investment? You take your net profit, which
in this case is $1,000 and divided by the amount that you have invested, which is $1,000.
So 1,000 divided by 1,000 is one, times 100 to get a percentage. And we end up with 100%
return on investment, which is really nice.
And now let's see what buying $1,000 of this hypothetical McDonald's stock would look like
in a margin account. Oh yeah. This is an important expression. So when you buy stock using money
that you borrow from a brokerage, it's called buying on margin. Just keep that in mind.
The $1,000 that we're investing this time around is a little bit different. Why? Because
I'm using $500 of my own money and I'm borrowing $500 from the brokerage to buy stock. So when
I leveraged the $500 from the brokerage, I increase my buying power to a thousand dollars.
Let's stick to the same best case scenario. So our $1,000 in McDonald's stock grows to
$2,000. And again, this $1,000 up here is pure profit. Again, everything in total amounts
to $2,000, but we have to pay the brokerage back the $500 that they gave us.
Let's figure out our return. First, we had this giant chunk that was $2,000, but now
we only have to worry about this $1,500 chunk because we've already paid back the brokerage.
Again, we have this $1,000 that's pure profit. But we only invested $500 this time. So our
net profit of $1,000 divided by our initial investment of $500 gives us two. Multiplying
two times 100 to give us the percentage, it gives us a 200% return. Does that make sense?
And again, this is why margin accounts might look attractive to some people. So getting
a 200% return instead of a 100% return is a huge difference. But this is when everything
goes well. What happens when things don't go so well?
Let's do another example. So this is what happens when things go wrong. So let's start
with the cash account. And let's say, for example, you decide to invest $1,000 in, I
don't know, Blockbuster Video. (singing) Your $1,000 investment is at risk because our favorite
VHS and DVD rental shop fails to see the future of streaming, and fails to make a critical
partnership with Netflix. Not only does Blockbuster not make you any money, you hang on, hoping
against hope that your stock is going to rebound. And this $1,000 dwindles all the way down
to zero. And a really important note, this dotted line at the bottom here, this is your
floor. And I know it sucks to lose $1,000, but with this cash account, your losses aren't
going beneath this floor. So you ate it on this Blockbuster stock. And I mean, you ate
all of it. You lost every penny of your $1,000. So what would you return on investment be?
Well, in this case, my net profit is negative. It's negative $1,000 because you lost everything.
So your net profit is negative 1,000 divided by the $1,000 that you've invested. That's
negative one. We multiply that negative one times 100 to get a percentage. And that's
a negative 100% return on investment.
Let's make the same Blockbuster investment using a margin account, and we'll see just
how quickly things can get much worse. Again, we'll buy $1,000 worth of Blockbuster, 500
using our own money. And then we'll buy 500 on margin with money from the brokerage. And
once again you eat it and Blockbuster tanks, goes all the way down to nothing. Not only
did you lose the $500 you've invested, but you also have to pay back the brokerage the
$500 that you borrowed. Let's get the ROI. So in this case, I still lost $1,000. So my
net profit is negative 1000 divided by the $500 that I invested. Negative 1,000 divided
by 500 is negative two, times 100 to make it a percentage. That is a negative 200% ROI.
And this is just a theoretical version to show you how it works. It doesn't actually
work like this in the real world. When you're dealing with a brokerage, which is a business,
things can get a little more complicated and you can end up losing even more money. Let
me show you how. Let's take a look at this little slider right over here on the right,
because this is very, very important. This is a limit that's set on your margin account
by your brokerage. And it's also known as a margin call. Now we can move this slider
up or down, depending on the brokerage. Once your account drops to that margin call level,
then you're required to add more money to your account. And if you don't for some reason,
and if I understand it correctly, you end up eating the loss from your $500 chunk, but
the brokerage gets their $500 back.
And that makes total sense. When you lend money, you want to get it back. But the brokerage
has just come up with a really smart way to safeguard against losses. So of course, they're
okay with you putting more money into your margin account. They're not going to be okay
with their brokerage taking losses. So remember with our cash account, we had this floor right
here that we can't go below? With margin accounts, it's important to know this line, because
this is your break even point. Go above this point, you make a profit. Fall below it and
you risk going into that margin call zone or worse. So if you're going to do margin
accounts, know what the risks are.
So what's the difference between a cash account and a margin account? Your standard cash account
is your own money. The money you put in to buy and sell stocks. And a margin account
is a leverage account. One where you borrow money from your brokerage to buy more stock.
With margin accounts, when buying stocks on margin, you have to be very careful, because
I think Siri said it best, with those accounts. There's an amount by what you can win or fall
short. And when you fall short, you have to cover that gap out of your own pocket. Yes,
there is risk associated with investing in the stock market, but when comparing cash
accounts to margin accounts, while margin accounts could potentially earn you a higher
return, you also risk greater losses.
Honestly, I've never bought stocks on margin, and I probably never will. I like keeping
it simple. I like knowing where the ground is. I want to know very clearly what my potential
losses could be. And I enjoy investing, but if I'm constantly worried about, "Oh my God,
I got to pay the brokerage back," then it takes all the fun out of it. I know people
that are hesitant to get into the stock market, think it's gambling. Personally, I don't think
it is, at least not exactly. But when your average, everyday investor starts playing
around with leveraged accounts, like margin accounts, that feels a whole hell of a lot
more like gambling to me than doing sensible, calculated investing with a standard cash
account. And that's why I think it's a terrible idea for most investors.
Now, if you're Warren Buffet or Peter Lynch or some investing phenom that knows the stock
market better than the market knows itself, then I'll shut my mouth. But let's be honest,
Warren Buffet probably isn't watching this video, but if you are, Hey Warren. And the
average investor isn't a Peter Lynch. The average investor, isn't an investing phenom.
I know getting these big returns can be really enticing, but you have to keep in mind what
the goal of stock investing is, to make a return on your money. But at the same time,
the other goal is not to lose money.
Well, that'll wrap up today's video. I hope it made sense. I hope it was clear. And more
importantly, I hope you got something from it. If you enjoyed this video, don't forget
to Bobby Boucher that like button. Please share, and if you're brave enough, subscribe
and join me on my journey to grow Mind Over Finance to 1000 subscribers strong. And in
the comment section, let me know if you have any experience with margin accounts, good
or bad. And I'll catch you in the next video.