The Wrong Way to Profit in a Plunging Market

Warren Buffett has famously said on many occasions, "Be greedy when others are fearful." But there's a difference between being greedy and being too greedy -- and unless you can tell the difference, you could take a devastating hit even when you're doing the right thing.

What's happening right now
Sure, many people are in a panic about the big drop in the stock market yesterday. It's always tough to see your wealth essentially disappear in a cloud of red pixels on your computer screen. Still, those who've been through similar downdrafts are bucking the trend (and their fear) and buying stocks on the cheap.

Putting more money into the market right now makes plenty of sense, now that share prices have fallen dramatically. In some cases, you may get a chance to buy stocks at levels they haven't seen in months or even years. And if you don't think that this is anything more than a long-awaited correction from the huge two-and-a-half year bull run that stock prices have seen since the worst of the financial crisis, then you might well expect a quick and handsome reward.

But in your zeal to take advantage of low prices, there's a mistake you absolutely need to avoid. If you have to borrow in order to buy more shares now, then the consequences could devastate your finances.

Why you want to
Buying stocks on margin is incredibly tempting right now. For one thing, interest rates are incredibly low. Depending on your broker, you can borrow against your portfolio at rates as low as 2% or less. Those are better rates than you can get on a mortgage -- even as those rates approach record low levels as well -- let alone a credit card or other types of debt.

Combine that with the fact that the carnage in the stock market is almost all-pervasive. It's not just lousy stocks that are getting taken out to the woodshed; even blue-chip dividend stocks have seen big losses. Consider that yesterday, United Technologies (NYS: UTX) , Chevron (NYS: CVX) , and General Electric (NYS: GE) all lost 5% or more of their value -- and each of them has a dividend yield that would more than pay for a 2% margin loan.

When you take a net income gain on your margin loan after taking dividends into account and add the expectation that you'll see a quick capital gain once the market comes to its senses, it can be almost irresistible to jump in and multiply your gains. But you can learn from the people who've done it before -- and lost everything.

Margin kills
Who's on the margin list of shame? Let's take a look:

Nor does this only happen to company executives. One of the most recommended discussion board posts in Fool history talked about a young investor who lost everything in the promising biotech Celera. After buying shares on margin from $130 to $170, the stock dropped to $85, and his broker forced him to sell everything -- and write a check for $1,500 to boot. Just this past May, Quest Diagnostics (NYS: DGX) bought out Celera -- for $8 per share.

Don't do it
No matter how attractive stocks may get in the current market swoon, they can always get cheaper still. Taking advantage of bargains is a smart move, but putting yourself in a position where you'd have to sell at even lower levels is dumb. Buying on margin puts you in that no-win situation.

Learn more about the big threat to your wealth in this video from the Motley Fool. Not only will it tell you how to protect yourself, but you'll also get a stock choice that has great potential even in a down market.

At the time thisarticle was published Fool contributorDan Caplingeris grateful that he didn't have to learn everything the hard way. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. Motley Fool newsletter services have recommended buying shares of Chevron, Quest Diagnostics, and Chesapeake Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool'sdisclosure policyalways attracts interest.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.