I recently had a friend start investing with margin and not going to lie, he has had some freaking awesome results with it! The thought of investing with margin was something that was always terrifying to be but it really made me question this belief. So, the question is – should we all be investing with margin?
First of all – what even is margin?
Investopedia says that “Margin is the money borrowed from a brokerage firm to purchase an investment. It is the difference between the total value of securities held in an investor’s account and the loan amount from the broker.”
Basically, people will borrow money to allow them to invest more than they currently have.
To tie it back to the example with my friend, he had about $15K in his brokerage account but by investing with margin, he was then allowed to invest in more companies, or maybe the same companies but by purchasing more shares, as his brokerage firm was letting him borrow that money.
Now, of course, nothing in life is ever free, so you’re going to have to pay interest on the money that you’re borrowing from your brokerage firm. I have found that the interest rate can vary greatly by the brokerage so if you were ever going to consider using margin, I really think that this needs to be your first step to doing the math if it makes sense for you.
Brokerage-Review.com put together a really comprehensive breakdown of all the various brokerages out there and their various interest rates and it’s definitely worth a look:
As you can see, not only does the interest rate that you have to pay vary greatly by the broker, but also by the amount of money that you’re going to be borrowing.
For instance, I invest with Fidelity, so when my buddy told me that he was using margin, I instantly looked at their rates. It’s over 6.5% for anything over $100K, and that just seems like an insane interest rate to me!
Doesn’t that seem crazy high to you?
There are some brokerage firms that are much lower but they also are some of these new, trendy names that might not come with the various investing tools that an investor would like, but that’s up to you to decide.
One firm that I did notice that was missing was Robinhood, and their margin rate was 5%, but let’s be honest – there are a ton of better brokerage firms out there than Robinhood.
The reason that this interest rate is so important might seem extremely obvious, but it is even more obvious when you’re comparing an interest rate with investing.
If you’re looking to buy a car or home, of course you care about the interest rate, but many people aren’t going to change their decision based on the rate. Quite simply, there are just more variables at play.
Buying a car or house isn’t just about money. It’s about being able to drive wherever you want whenever you want. Having flexibility to have an easier life. Being able to drive to work rather than having to take public transportation.
And a home – a place to make memories. A place where your payments aren’t going to go up. A place that you can upgrade your house and ideally get that value back if you ever sell.
There are more things at play that are considered.
When you’re investing with margin, all these emotional things are not at play. It comes down to 1 thing – the return!
The return that you are going to make has to outperform the interest that you’re paying. If you invest $7500 with Fidelity then you’re going to pay well over 8% interest each year. So, if you only earn 6%, then you essentially just lost 2% on your $7,500 investment!
Your $7500 is now worth $7350. Obviously, that is something that we all want to avoid, right?
It really just comes down to this – what sort of return can you actually anticipate earning with this extra money that you’re borrowing?
Obviously, that question is one that is impossible to answer with certainty, and that’s what makes this so stressful. Over the course of time, if you were to simply invest in the S&P 500, you would be happy paying 8.33% interest.
I recently wrote a post on how the S&P 500 has performed through mid-2020 based off a few different starting years. In general, the return was well above 8%, but the return from 2000 was not one to write home about:
Sure, you’re only losing .09% every year, but you’re losing money. And this is also assuming that you’re investing in the S&P 500 only. Maybe you would invest in a company like AAPL or AMZN, both of which were actually volatile penny stocks at one point.
Or, maybe you would invest in some of the mecca companies like Exxon Mobil or General Electric, both of which would be extremely disappointing investments although likely seemed like the surest of investments at the time.
The thing with investing is that you simply don’t know what the future is going to bring. And when you’re investing with margin, the only thing that matter is your return. It’s simple:
If your return is greater than your interest rate, you would want to use margin.
If your return is less than your interest rate, you would not want to use margin.
That’s it! That’s the entire scenario that you need to evaluate from a mathematical situation. Now as I mentioned, that is something that is quite simply impossible to predict, and literally anything can happen that’s going to potentially make the market crash, all the while you’re paying 8.33% interest on top of losing your investment value.
As I said, this really is the entire the mathematical aspect of investing with margin, but I urge you to think a little bit past the math. I know that’s not always easy, especially for someone like me that is so tied and obsessed with the numbers, but there are some other aspects that I URGE you to take a look at. Let’s look at some more of the qualitative pros and cons of investing with margin:
As you can see above, I think that there are really three main pros to investing with margin – higher reward, flexibility and compounded CAGR.
The higher reward is simple – if you originally had $5K to invest and now you have $10K, and you the market goes up 11.50% like it has on average since 1928, then you’re going to make $1,150 instead of only making $575 because your base investment is double.
Now, you have to remember that you’re going to pay interest on that second $5K that you have because you’re borrowing it, so after your insurance costs, you’re really going to be at a lower number like $10,733.50 as you can see below:
But even after paying that crazy high interest rate of 8.33%, you’re still sitting there with a pretty nice profit of 3.17%!
Along with the high reward potential, you have increased flexibility to invest how you see fit and not have FOMO!
For instance, imagine this situation:
You have $10K perfectly allocated in 10 stocks that you love and then one of those stocks drops 20% in share price and you REALLY want to buy more – what do you do?
Well, you can either find a way to get more money in your account, sell some of your current positions to free up cash, or do nothing…or you can invest with margin! You can use this extra purchasing power to really increase your flexibility.
You’re not going to use margin 24/7, but maybe rather in an opportunistic way. If a situation arises that you want to take advantage of, you can! And when you’re not using margin, you’re not paying interest on that money. So, it’s really an “opportunity fund” in a way that can help set you for those exciting opportunities that you see in the market!
And finally, you’re actually getting compounded CAGR, or Compound Annual Growth Rate. What do I mean by that? Well, it’s CAGR on STEROIDS!
Let’s use that example that I gave previously to help showcase. If you were only going to invest $5K for 30 years, and every single year you made 11.50% on your money, you would have nearly $131K! That’s not bad at all.
But, if you invested with margin and paid that 8.33% interest rate on the amount you borrowed, you would have ended this 30-year period with nearly $304K!
That’s 2.32 times the amount that you would have if you didn’t use margin and that’s purely by doing nothing different other than using margin.
Now, this does sound all fine and dandy, but there are some major cons that you need to consider with margin as well, and one specifically can poke a major hole in this theory…
On the flip side of getting a higher reward by investing with margin, you’re also opening yourself up for higher risk. There is a potential that the market doesn’t go up as much as you’re anticipating, and honestly, that potential is pretty high!
If you were to invest with margin since 2000 then you would’ve actually lost money each year as the average return has been 7.91% and you’d be paying 8.33% in interest. This isn’t a huge amount to lose, but nobody wants to lose money, especially over a two-decade time period.
In addition to higher risk, I think that maybe the biggest potential con is that you’re going to be susceptible to margin calls. Margin calls are a brokerages way of protecting itself. Basically what happens is if you’re going to be investing $5K of your own money and $5K of margin, then if the market drops by a significant amount, the brokerage might ask for you to put up some additional capital to cover the amount that you had borrowed.
So if the market drops 30% and your investment is now down to a total of $7K (only $3500 is your cash) then the brokerage might ask for you to put some incremental cash into your account to keep the balance the same because they’re getting nervous that the value has crashed.
Honestly, it’s a tough situation because normally when you borrow money, you can do whatever you want with it and there’s no transparency to the lender about how that money is being used. But in this case, you’re borrowing from your brokerage firm so they know exactly how their money, that you are borrowing, is invested and what the current value is.
If it increases, great! They will let you borrow more. If it decreases – not great. They might come to you and demand for you to add some cash, meaning you better have cash on hand or you’re going to need to be prepared to sell some stocks.
And guess what – margin calls only occur when investments drop in value. So, if you’re getting a margin call, the brokerage firm is forcing you to sell low. Kinda the opposite of the whole “buy low, sell high” philosophy, right?
And finally, the stress simply just might not be worth the potential increased returns. If the situation that I just laid out for you causes you anxiety, stop reading. Hit the back button and go read a different great blog post of mine (lol) or checkout the podcast.
If you’re stressed simply by learning about the pitfalls of margin investing, it’s going to be a billion times worse when your money is actually at risk in the market.
The stress is going to eat you alive. It simply won’t be worth the small opportunity that you might have for some extra profits.
At the end of it all, investing with margin absolutely could open some doors for opportunity that you might not have had otherwise, but you need to be smart about it. Trying to invest all willy nilly and day trade is going to get you in serious trouble, and even more so if you’re using margin.
If you’re stressed about the thought of this – stop. Don’t think about it ever again.
If you’re going to use margin, just be smart. Make sure to continue to use your stock checklist, finding great companies from all different sorts of places, and of course by making sure that they’re undervalued vs. their intrinsic value!