Investing on Margin Looks Simple, but It Really Isn't

It takes money to make money, we're told, and that can certainly limit our ability to invest in great stocks. For example, if you'd put $100,000 into Shopify at this time last year, you'd have returned something like $150,000 in profit by now -- if only you'd had that free cash to invest back then. This explains much of the visceral appeal of buying stocks on margin. Borrow money at an annual interest rate of, say, 5%, and all you have to do is pick stocks that will return you more than that, and voila! Money for nothing.

That concept sounds appealing to Motley Fool Answers listener Dakota, so in this segment from the July mailbag show, hosts Alison Southwick and Robert Brokamp ask special guest Ross Anderson, a certified financial planner at Motley Fool Wealth Management -- a sister company of The Motley Fool -- to explain where the pitfalls and risks in margin investing are hiding. Spoiler alert: They are not insignificant risks.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.

This video was recorded on July 30, 2019.

Alison Southwick: Our next question comes from Dakota. "What are your thoughts on margin investing; i.e., investing with borrowed money? The current interest rate for margin investing on Robinhood is 5% yearly. My thoughts are if my portfolio does better than 5% -- for example, 7% -- I would be making a full 7% on my actual dollars invested and 2% on my margin investing after the 5% interest is paid."

Ross Anderson: The question, here, I think, is a good one. It's one that I've pondered as to how you could structure this. I think there's a couple of moving targets, here, that make this really difficult to execute. The first is that when we say the stock market typically yields 7-9% or somewhere in that range, that is a very erratic 7-9%. In the last 39 years -- if you look at the S&P 500 and look at how many times it has actually returned between that 7-9% -- even though we think of that as the range and the average that it stays in, it's only been two years.

Most of what we're seeing is big up years, big down years, flat years; so, you don't necessarily have that predictability to say, "Yes, I'm going to put my money in. It will earn 7% and I'll pay 5%. That's cool." If I could do that, predictably, I'd be very comfortable doing that and everybody would do it.

Let's take a year like 2018. The U.S. stock market lost 4.38% on the S&P. If you had made a $50,000 investment -- and you'd taken it up to your typical margin limit at 50% and bought $100,000 of the S&P with it -- through that year you're going to pay $2,500 in margin interest at 5% and then you're going to lose $4,380. You've got a 14% loss on your capital that you invested relative to the market losing 4%. You exacerbate those losses in an unpredictable market. So you've got to be really tolerant of risk to be willing to take that on.

The flip side of that is that if you had ridden that same train all the way through this first half of 2019 you would have made money and that's where this is kind of tough to tell people not to consider it. But you want to be very, very careful using margin because it's going to cut both ways just as fast and when you're losing that money it's tough to hang onto that ride.

The other thing I'll say is that margin interest is generally going to be a floating rate interest. It's not going to stay stable at 5%. We're in continued historically low interest rate times, but I would expect your cost to borrow, there, is going to continue to rise in the future. It may not be this year because we're looking at Fed decreases in rates maybe this year, but long term it's unlikely that you're going to be able to hang on at 5% forever.

I understand the math. I understand why you would be thinking that way, but I think it's much better to play a long game with the stock market and not to invest more than what you actually have to lose.

Southwick: I've never invested on margin. Would Robinhood ever, for example, be like, "Oh, you've lost too much. I'm sorry. We're closing this."

Anderson: Yes.

Southwick: You can't just ride it out and be like, "I know the stocks. This is a bad period, but I know in five years' time this stock is really going to pay off."

Anderson: Most of the time you're going to have an initial margin limit which is normally 50%. You could basically buy double what you have in there. That's why I used the example of you could have $50,000 and buy $100,000 in stocks. Then your margin call limit, I believe, is normally at 30%. And if you get less than 30% equity in the account they're going to start selling for you.

Southwick: Lock in those losses.

Anderson: You're not going to get to choose the day. It is going to be a violent experience because they're going to protect their money more than yours. They do not care if you lose money in that process. That doesn't make them an evil company. All brokers treat it that way.

You basically end up in a position where they could say, "We're going to sell your positions unless you add more money right now, because you've lost too much of our money." It's a very risky proposition. I would not recommend it unless you're very, very comfortable with a lot of risk and you consider yourself a pretty sophisticated investor.