Advanced Diploma of Financial Planning (ADFP) Practice Test

What is the key advantage of margin accounts for investors?

1. They provide a fixed return on investment

2. They allow borrowing funds to purchase additional securities

3. They limit the overall risk taken by the investor

4. They guarantee profits regardless of market conditions

The correct answer is: They allow borrowing funds to purchase additional securities

Margin accounts offer a significant advantage for investors by allowing them to borrow funds to purchase additional securities. This ability to leverage investment capital means that investors can potentially increase their buying power and invest in more securities than they could solely with their own capital. When investors use margin, they are effectively amplifying their potential returns, as any gains from the additional securities purchased are magnified. This method can enhance investment strategies, especially in bullish market conditions where the likelihood of asset appreciation is high. However, it’s important to note that while the potential for higher returns exists, so does the risk of greater losses, as investors are responsible for repaying the borrowed funds regardless of their investment performance. Other options, such as providing a fixed return on investment or guaranteeing profits, do not accurately characterize the nature of margin accounts, which are inherently subject to market conditions. Moreover, limiting overall risk is not a feature of margin accounts, as they can actually increase risk exposure due to the involvement of debt.