Should I invest on margin?

Question

I have an Interactive Brokers margin account, but so far, I haven't been using the margin; I'm considering doing so.

According to https://www.interactivebrokers.com/en/index.php?f=18069, their interest rate below $25k (which is the range I'm considering initially) is 3.42%. If I consider the historical stock market data from 1986-2016 from https://www.thebalance.com/stock-market-returns-by-year-2388543, I determine an arithmetic mean of 11.8% and a geometric mean of 10.4%.

Therefore, assuming that the last 30 years are indicative of the returns I would get in my time horizon (which could be 5 years or so), it seems very attractive to invest with margin as then I would still earn 6-7%.

Does this reasoning make sense? Are there factors I haven't considered?

Answer 1

Are you prepared to meet margin calls?

If the value of your holding falls enough that you drop below the minimum maintenance margin, the broker can demand that you add additional assets to bring your account back over the maintenance margin. If you can't meet their demand, they can force a sale of your holdings.

In other words, if you are buying on margin, a temporary decline in the value of sound long term holdings may force you to liquidate them in very unfavorable circumstances.

Answer 2

Well one thing you seemed to not have considered, basing your returns purely on past average returns over 30 years, is that if there is a downturn within your 5 years or so of investing, you may not only not recover your investment returns but you will be getting charged interest as well.

Don't get me wrong, if you think you can take advantage of margin to help increase your returns, then good go for it. However, I think before you start you should not only look at what can go right (ie. potentially higher returns), but more importantly you should carefully consider what can go wrong (ie. potentially higher losses) and develop a risk management plan spelling out what your actions would be if certain things don't go as you presumed.

The worst thing that can happen is if you have no plan and things start heading south and then you panic sell or just remain paralysed not knowing what to do or what action to take and watching your account fall off a cliff. You want to avoid having sleepless nights.

I will give you an example of having a plan, a real life example, my own situation. I trade individual share CFDs on margin, my actual physical account I have started with is $50K, however the margin allows me to trade a virtual account up to $200K. Basically each individual share has a margin of between 5% to 30%. At 5%, for a $10,000 stock purchase my actual outlay would be $500 and I would pay 4%p.a. interest on the full $10,000 each time I keep the position open overnight. At 30%, for a $10,000 stock purchase my actual outlay would be $3,000 and again I would pay 4%p.a. interest on the full $10,000 each time I keep the position open overnight. I have conservatively used an average margin of 25%, allowing me to trade up to $200,000 worth of shares on only $50,000 of initial capital.

The first thing in my plan is not to overtrade. To do this I position size each of my trades. I also have conservatively used an average margin of 25%, allowing me to trade up to $200,000 worth of shares on only $50,000 of initial capital. My actual average margin would be closer to 15% allowing me to actually trade up to a virtual account of over $300K. Why have I done this? To be conservative and to allow a margin of safety in case the market does start heading south, so I don't end up getting margin calls and have to sell in a hurry and in a mad panic.

The next thing I do is to have a stop loss order on all of my trades as soon as the order gets triggered. I use a 16% trailing stop loss which allows me to capture the medium term uptrend but protects me if the stock starts down-trending. It also allows me to remain in my position during normal daily swings up and down, usually not stopping me out prematurely.

I also use the 16% stop loss to work out my position size, and try to maintain a portfolio of 15 stocks. Most people new to margin get in trouble by overtrading. Without margin they could afford to take out a position worth $10K, now with margin they can take out a position worth $100K, so they do just that thinking when it goes up in price they will make 10x the profits. However, they do not consider the consequences if the price starts dropping sharply.

I had back-tested this strategy over both 5 years and 10 years (to take in the effects of the GFC). Over 5 years the average annual return was approx. 20%p.a., turning $200K into over $420K. Over the 10 years the average annual return was approx. 15%p.a., turning $200K into over $500K, mainly due to being quite flat over 2008 and 2009, because the trading strategy does not trade when the overall market is down-trending.

I started live trading the strategy in early February this year and in just under 5 months my profit is $25K, 12.5% on my virtual account of $200K and 50% return on my actual account of $50K. My win percentage is currently 65%, and my average win size is just over $2,000 whilst my average loss size is just over $1,200. I would like to get my average win size to at least 3x my average loss size over the long term.

As you can see, another benefit of planning and recording all your trading outcomes is that you can review the performance of your strategy over time.

So to summarise, before you do start trading with margin, have a risk management plan in place and do not overtrade either on any one trade or over the whole account - leave a buffer so that you don't need to panic when things don't go your way.

Answer 3

Are there factors I haven't considered?

Margin calls.

Your reasoning is all very logical. The issue is when (not if, when) your investment drops such that some needs to be sold or you need to wire in more money. Looking at long period averages is all well and good. Living through the volatility is a lot different, and margin calls are real.

Answer 4

In a sense, margin leverages losses more than gains. This is related to the dreaded margin call. If you invest with 2x leverage, and your stocks fall 25%, you will be forced to liquidate with a loss of 50%. Your wealth has been cut in half. Even if you start over again with 2x leverage, you now need a 50% gain in your stocks to get back to even (ignoring interest costs).

Another way to look at it is that even in a cash account, you can effectively invest on margin, at attractive rates, by buying a leveraged ETF. These try to maintain constant leverage and still are biased toward losses, only slower. They are hardly a no-brainer investment and you can read about their various problems. For 2x leverage on the S&P 500, you can look at the historical returns on a daily-rebalancing fund (SSO) and a monthly-rebalancing fund (DXSLX). If you held on, you'd have gains, but they underwent sickening ~90% losses in the Great Recession.

EDIT: To show that the percentages here are not "derivative math manipulation", assume buying the S&P at 2400 with 2x leverage. If the S&P falls 25% to 1800, and you are liquidated or stopped out, you have lost 50% and so you have much less capital to recover with. The S&P has to rise 33% to get back to 2400 (the usual loss-vs.-gain percentage behavior), but this does not make you whole. Instead, if you get back in with 2x leverage at 1800, you need the S&P to rise 50% to 2700 (300 absolute points higher than it started) for your portfolio to break even. This is the geometric compounding problem with margin. A 100% loss is the extreme case, but the problem is visible well short of that.

Answer 5

Margin is a double edged sword. On 50% margin, it's twice as good to the upside and twice as bad to the downside. To succeed with it, you need several ingredients.

First and foremost, you need a plan. Perhaps more importantly, you need the ability to practice disciplined risk management because there will come a day when it will hit the fan. It will be a fast market and if you don't know how to react to that methodically and unemotionally with a clear head, you'll watch the $$ in your account disappear in front of your eyes. You will be the deer in the headlights, IB wil auto liquide your positions and/or your account and you'll be wondering, "Where did my money go to?".

From your question, I sense that you have this germ of an idea that based on long term probability and you're willing to take a risk that you're not yet equipped to manage. Using margin borrowing simply because the lending rate is low (particularly at Interactive Brokers) and because the historical stock market return is greater than 10% is a very bad plan.

Investing/trading on margin is not a bad thing when you know how to properly utilize it, manage it and mitigate its potential damage. If you don't, avoid it like the plague.

And not that I'm encouraging you but selling Box Spreads (options) is a way to fund margin borrowing with lower cost. That requires a whole nuther level of experience.

Answer 6

Historical returns are just that, historical.

Today, due to the low interest rate environment, money has fled into alternative assets such as stocks from fixed-income assets, meaning stock prices are, mildly said, overvalued today. This means that in the extremely long term, your returns are likely to be approximately 7%, unless the stock prices become significantly lower very soon, making it possible to reinvest dividends in a more favorable environment. (Investing on margin means you don't want stock prices to sharply decline; investing long-term means you actually want exactly that due to the dividend reinvestment opportunities.)

Remember also that historically, a long time ago, inflation used to be much higher than it is today. Today, you can expect 2% inflation whereas it used to be much greater. Be sure to take a historical time period with consistent 2% inflation if you want to determine the historical returns of stocks. Or alternatively, you can calculate the real return and add 2% (for current inflation) and subtract 2% (for current high stock valuation levels) to get the expected nominal return today.

3.42% versus 10.4% is entirely different than 3.42% versus 7%. And for the question you didn't ask: geometric mean is what should be used to estimate stock returns, not the arithmetic mean! And also, the 7% does not have taxes deducted from it yet!

The only reason I'm very slightly investing on margin is that I have a stable job, and the margin is actually a student loan guaranteed by the government, a loan I won't have to pay back anywhere soon, and I'm guaranteed not to experience a single margin call due to the government backing of the loan!

I would not take the opportunity to invest on margin in your circumstances. Just to make it explicit: my loan has variable 12 month Euribor rate + 0.2% added on top of it, meaning the interest rate is approximately 0% today due to the negative Euribor rate. It will be paid back probably 15 years from now. No way would I invest on margin at current stock valuation levels if my student load had 3.42% rate, even if the government backing guaranteeing no margin calls was there!

Answer 7

The accepted answer is not incorrect per se but it doesn't really answer the question. Maybe some of the TL;DR ones do but I don't know because TL;DR.

Therefore, assuming that the last 30 years are indicative of the returns I would get in my time horizon (which could be 5 years or so), it seems very attractive to invest with margin as then I would still earn 6-7%.

Does this reasoning make sense? Are there factors I haven't considered?

The math that gets you to 6-7% is not really the right way to think about this. What margin does is magnify the gains and losses on your investment. For example, let's say you get a nice round 10% on a $10K investment over a year. By itself you would get 1000. If you then invested another $10K on margin you would get 2000 minus say 3% in interest or 1700. Comparing that back to your initial investment, you earned 17%.

On the other hand, let's say you lost 10% over the year. That $20K becomes $18K. And for simplicity let's assume you must close out your position. You owe the brokerage $10.3K leaving you with $7700 of your original investment for a 23% loss.

So a simple way to think about this is that your are essentially increasing the risk of an investment when you buy on margin. When I say risk here, I mean in the financial sense in that you get paid more for risk. So the question you need to ask yourself is do I want to increase my risk profile? And if so, would it make more sense to simply move some of your investments into higher risk investments?

Answer 8

The answers here warning you of the risk of margin calls are all correct. More specifically, you should run the scenarios. Lets assume you buy $50k worth of stock (say 1,000 shares at $50) with $25k of your money and $25k borrowed from your broker. So to start your investment will be worth $50k-$25k = $25k.

What happens when the price declines? If the stock price drops to $45, a decline of 10%, your investment now only worth $20k, a 20% decline. Now lets also assume your broker has a 50% margin requirement. Your broker is going to require you to pay down $2,500 of your margin loan to keep it 50-50 between your money and theirs. What happens if the market plunges a total of 40%? Now the stock is worth $30k, and you would have had to pony up $10,000 total to your broker to stop them from selling your shares and your total loss has actually reached $20,000, or 80%. And none of this factors all the interest you paid for the "privilege" of borrowing money from your broker.

And if you could come up with money to meet margin calls, why wasn't that money invested in the first place? Keeping $10K accessible in something earning nearly zero interest to enable you to meet possible margin loans is backwards. Buying $35k of stock without using margin provides you with nearly as high returns in the long run (factoring in interest savings), greatly reduces your downside in bear markets, and has zero risk of margin calls. In reality, a highly leveraged investor doesn't have reserves and can't meet margin calls, so their broker sells out their positions locking in huge losses at the worst possible times. And it just has to happen once to destroy your long term returns.

Another answer suggested protecting yourself with stop-losses. While that's a mandatory strategy for leveraged traders, it's an extremely foolish strategy for long term investments. If you are a good investor, you purchase shares because they are worth substantially more than what you paid for them. If you buy shares at $50 thinking they are worth $80+, why would you ever put in a stop-loss to sell them at $42.50? Run the numbers on investing in the stock market long term with a leveraged portfolio that is liquidated at a 20-30% loss every time the market drops 15%. It will get crushed long term, probably not even produce a positive return. 15% declines happen a lot more often that you will like.

Let me finish with a personal story. When I was younger I devoted myself to long term buy and hold value investing, mostly in small cap stocks and driven by intensive research. My returns were so great that within a few years I was able to retire to invest full time. After a few years I decided it would be foolish not to use leverage to juice my returns even more. Being fully aware of the dangers of margin loans, instead I borrowed a substantial 2nd mortgage thinking I was being smart, because I would never have to worry about a margin call, and put it all into my best ideas.

That 2nd payment drove up my monthly expenses substantially, but I was making so much I could afford it easily. Then my daughter became ill with a long term condition, and since I was self employed we had to pay for her expensive therapy (starting around $10,000 a month). But again, I was crushing the market so could easily pay for that too.

Then the 2007-2008 stock market crash occurred. Stocks I estimated were worth $10 were suddenly trading at $2. It was the greatest buying opportunity of my life, but I was locked out, as I was fully invested with no spare cash. But far far worse, my only option to cover that gusher of monthly expenses was selling shares, so I regularly locked in massive losses selling for prices half what I had paid. When the market was 50% down, I was down even farther because of that leverage and burning through the remainder of my portfolio at a rapid rate.

Before I lost everything I finally realized the only way to pay for my daughter's care and keep our house was to go back to work. The good news is my daughter is great now and we still have the house, but I had to work some shitty jobs for a number of years to do it, and I'm never going to be able to retire early again. Hopefully you and others can learn from my painful experience, and be extremely careful about using any kind of leverage on investments as volatile as the public stock market.

Answer 9

The dangers others have highlighted notwithstanding, yes, you probably should invest on margin, especially if you are young.

Investing on margin increases both the returns and volatility of your investments. There is a sweet spot between safety and danger called the kelly bet. A good rule of thumb is to invest at around half of what the kelly bet would say, to guard yourself against over estimating return and underestimating risk. For the S&P500, in isolation, this is around 120%, if I remember correctly. So it would make sense to invest in an index fund of the S&P500 with all your money plus around 20% margin. More than that increases the volatility of your investment more than it increases the return, regardless of the margin rate you're given (unless maybe it's negative, and you're getting paid to invest on margin). Past 240% the volatility swamps the extra return and your expected value decreases rather than increases.

This assumes you have the risk tolerance for this strategy, however. That's both your particular tolerance to financial risk and your time horizon. The younger you are, the more you can afford your investment to dip for a decade if it increases your returns in 30 years.

Speaking of being young, investing on margin also lets you spread your risk across time. When you're young, you have lots of risk tolerance but little money. When you're old, you have lots of money but low risk tolerance (because you're retired and living on your money, not because old people are risk adverse. Though they are). By investing on margin when you are young you are borrowing money from your rich future self. There's an associated increased risk, but you're only risking a tiny fraction of the total amount of money you will ever save. Losing your entire retirement fund at 25 is unlikely to set you back very far, for instance.

As with anything investment related, make sure you understand the implications of what you're doing, especially the risks. But margin trading is an underused tool.