key term - Buying on the Margin

Definition

Buying on the margin refers to the practice of purchasing stocks by paying only a fraction of the total price, while borrowing the remainder from a broker. This method allows investors to leverage their investment, potentially leading to higher profits but also greater risks, especially during periods of economic instability such as a global economic crisis.

5 Must Know Facts For Your Next Test

1. Buying on the margin became popular in the 1920s, allowing many investors to purchase more stocks than they could afford outright, which contributed to the stock market boom.
2. The practice is closely associated with the stock market crash of 1929, as many investors who bought on margin faced severe losses when stock prices plummeted.
3. When the market declined, brokers issued margin calls, forcing investors to either deposit more money or sell off their investments at a loss to cover the borrowed amount.
4. Regulations were established in the aftermath of the Great Depression to limit buying on margin and protect investors from excessive risk-taking.
5. The impact of buying on the margin during economic downturns highlights the interconnectedness of financial markets and the broader economy, illustrating how individual investment choices can lead to widespread financial instability.

Review Questions

• How did buying on the margin contribute to the stock market crash of 1929?
  • Buying on the margin significantly contributed to the stock market crash of 1929 because it allowed investors to purchase large amounts of stocks with borrowed money. As stock prices began to fall, many investors found themselves unable to meet margin calls, leading them to sell off their stocks in panic. This mass selling further drove down stock prices, creating a downward spiral that culminated in a devastating market crash.
• What regulatory changes were implemented in response to the risks associated with buying on the margin during economic crises?
  • In response to the risks highlighted by buying on the margin during economic crises like the Great Depression, regulatory changes such as the Securities Exchange Act of 1934 were introduced. These regulations aimed to protect investors by establishing rules regarding margin requirements and improving transparency in trading practices. This was crucial in preventing excessive speculation and promoting stability in financial markets.
• Evaluate how buying on the margin reflects broader themes of risk and speculation in financial markets and its implications for global economic stability.
  • Buying on the margin exemplifies broader themes of risk and speculation within financial markets, showcasing how individual investment strategies can have far-reaching effects on global economic stability. By allowing investors to amplify their potential returns through leverage, it creates an environment ripe for speculation, which can lead to bubbles. When these bubbles burst, as seen during the Great Depression, it results in significant financial turmoil not only for individual investors but also for economies worldwide due to decreased consumer confidence and spending.

Related terms

Stock Market: A marketplace where shares of publicly traded companies are bought and sold, serving as a barometer for the overall economic health.

Leverage: The use of borrowed funds to increase the potential return on investment, which can amplify both gains and losses.

Margin Call: A demand by a broker for an investor to deposit additional funds or securities into their account to cover potential losses when the value of margin-held securities declines.