A blog reader posted a question recently asking my views on buying stocks on margin. Since margin loans are simply another form of investment borrowing, the question for me really boils down to being about asset allocation. Let’s start with two basic asset classes, 1) risky assets (stocks, real estate, commodities, etc.) and  2) less risky assets like bonds and cash. Of course the two always have to add up to 100 percent. Take the example of a simple portfolio for someone with a long-term time horizon who holds 80% stocks and 20% cash. We can drive up both the expected return and risk of the portfolio by instead choosing 100% stocks and 0% cash. Most investors understand this relationship between risk and return. However, we can become even more aggressive by aiming for a still higher return and commensurate higher risk by allocating 110% stocks and ‑10% cash. The negative cash balance is really just borrowing, which investors can achieve through means like a margin loan.

So what are my views on borrowing on margin? For the right situation, margin loans can be a perfectly acceptable way to increase the expected return and risk of a portfolio. Based on historical data, an investor with a very long time horizon and a high risk tolerance will earn a higher return than just the market’s return by borrowing. However, it’s critical to remember the inherent risk and the challenge of staying invested during inevitable downturns, when leverage like margin borrowing exaggerates the downward swings the same way it does the upward swings. Furthermore, your overall asset allocation can affect the wisdom of margin borrowing, e.g. it can be foolish to borrow on margin if you have part of your portfolio in cash (money market funds) since for that portion you’re simply borrowing at margin rates in order to invest at money market rates, almost always a negative carry.

Margin borrowing offers only one approach to increasing the leverage of a portfolio. Another method is to use derivatives like index futures contracts, which allow investors to create an asset allocation of greater than 100% in stocks. The ideal source of leverage will depend on which rate provides the lowest implicit or explicit borrowing rate, including tax impact, if any. Keep in mind that for both futures contracts and margin loans, an investor enters a world where losses can potentially exceed the original amount invested. Another perspective to remember is that in the long term such leverage may be advantageous, but you need to make sure you can survive until that long term arrives. In any game of chance with a positive expected return, the players with the deepest pockets have an advantage since they can outlast others in bad times while waiting for the law of averages eventually to swing back to their favor.