Robinhood announced last night that it's lowering its margin rate from 5% to 2.5%, and I've been extremely excited about it, so excited in fact that when I woke up this morning I thought it was a dream. Although Robinhood has become a bit of a meme, I thought I'd take a minute to explain why I actually do think this is a big deal. The TLDR is that the argument for one of the more (as far as I can tell) contrarian pieces of potentially broadly applicable personal finance advice that I believe could apply to lots of young people seems to have just gotten a lot stronger.
A disclaimer: I’m describing and publishing the following strategy to get input from a broader community of people, not to offer financial advice. I am deeply, profoundly even, not your financial adviser, and you should not pursue the following strategy without substantially more time spent researching it, until you’re sure you understand what I’m describing fully, and especially until you’re sure that you understand the risks it exposes you to. If this is the first time you’re learning about how the concepts I’m describing work, then you should read a lot more before acting based on any of this. While I’m very confident I’m not wrong about the basic mechanics of the strategy I'm describing, I may be very wrong about the conclusions I draw.
What Is Margin?
When you "use margin", what you're really doing is better thought of as "taking out a margin loan". "Margin" is just a loan that's explicitly given for the purpose of buying some asset. It can only be provided by a broker, and when it is it can only be used to buy the asset that the broker is a broker of. What we call "margin" for stock and bond trading we call a "mortgage" when purchasing real estate.
The issue with doing this, of course, is that you're on the hook for the loan no matter what happens to the price of the asset. Say you take out a $1,000 margin loan and buy a stock with it. The net value to you of your account, or your "equity", is still $0, because while you now have $1,000 in stock you also have an outstanding $1,000 loan. If the stock goes up 10% and you now have $1,100 in stock, you've now become $100 richer without putting up any money. If the stock goes down 10%, and you now have $900 of stock, you're now $100 poorer without having put in any of your own money.
In practice, since margin loans also need to be "collateralized" (meaning insured/guaranteed) by money you do put up yourself, using a margin loan has a leveraging effect. The absolute minimum (legally) amount of your own money that you would need to have invested before a broker would let you take out our hypothetical $1,000 margin loan above is also $1,000. This means you need to have already invested $1,000 with the broker before they'll let you make the move described above. If you've already invested $1,000 with the broker, they will let you take a $1,000 loan from them to buy more. Since the ratio of the money you put in to the money you were loaned in this scenario was 1:1, you would, after executing the above, be "leveraged 2x", which means you will get outcomes twice as extreme as you would have had otherwise. We can do this out quickly to see why: You now have $2,000 in stock (your "account value") but only $1,000 in equity (the net value of the account to you) because of your outstanding $1,000 loan. If the stock you've bought goes up 10% your account value goes up to $2,200 and your equity in the account becomes $1,200. Since $1,200 is a 20% increase from $1,000, because you were "leveraged 2x" your percent increase was twice as large as it would have been otherwise.
Margin "rates", meaning the interest rate charged on these loans, have traditionally been somewhere in the range of 9-12%. At this interest rate, margin is expensive enough that it only makes sense to use if you have a bet that you desperately want to make faster than you'll have the capital, or fresh cash, to purchase.
There's an easy way to think about what paying margin interest means for you financially: When the margin loan you're taking has an interest rate, your goal is to get a return larger, as a percentage and over each year, than that interest rate. Any amount of return above the interest rate you get to keep, and any amount of return beneath the interest rate you're left owing to your broker. If you have a loan charging you 9% and your investment returns an annual return of 12%, then the loan is generating you personally (12-9) = 3% of its principal value every year. If you only return 5%, which would not be unusual at all historically even for assets that did well over time, you'll see a growth of (5-9) = -4%, or losing 4% every year. If your investment drops 20% over a year, which, again, happens all the time, then your "growth" is (-20-9) =-29%, meaning that you now owe your broker almost a third of the loan principal's value. Since, 9-12%, in the long run, is considered a very high rate of return for any asset, investing on margin has historically been a very bad idea, even if you were investing in something extremely reliable.
However, in recent years, there has been some competition around this number. Interactive Brokers, an online broker that brands itself as being for more experienced investors, offers a margin rate that is pegged to a fixed amount above the "benchmark rate", which we won't get into detail explaining here, but can be thought of as the most expensive rate given on debt to the U.S. Treasury, and is typically very low. Over the last decade, this means that Interactive Brokers has often offered an interest rate of about 3%.
What Lower Rates Might Mean for Passive Investing
There's a massive difference between 9% and 3% in investment returns, and things that looked unappealing at 9% interest could look like a no-brainer at 3%. In general, financial advisers and conventional wisdom say that, over the very long run, on an index of the whole stock market (think the S&P 500, or ideally even something with more global reach and that includes smaller companies as well, like Vanguard’s Total World ETF), investors should expect a 6-7% annualized return. As far as I can tell, while many reasons are given for why this is, none are that much stronger than "because that's what it's been annualized over the last 90 years". There are many convincing arguments for why, and in my opinion epistemic conservatism suggests, it in fact should not be true going forward. Just one of these is that this number is typically given as guidance for what to expect from the U.S. stock market specifically, and analyses of this kind are heavily subject to a survivorship bias. If the Allies hadn't won World War II, for instance, because the Nazis had pressed their advantage more at Dunkirk, we wouldn't be sitting in San Francisco talking about how reliable the S&P's 7% growth has been over the last century.
Despite this, I've long thought that Robinhood's margin interest rate of 5% is low enough that it probably, roughly, made sense to take out a loan and use it to buy a broad index of U.S. and international stocks, perhaps especially for young people. If your portfolio is leveraged 2x, as we discussed before, on a very broad index of stocks, you can think of your investment as growing first by the amount of your return, and then getting a bonus, or penalty, for how you performed relative to your interest rate. If your portfolio grabs that oft-expected 7%, you get your 7% return, plus a 2% bonus for doing 2 points better than Robinhood's 5% interest rate, getting you 9%. If you only pull a 3% return, you get your base 3% plus a penalty of -2 for underperforming the interest rate by 2%, giving you a return of 1%.
Very importantly, note that this logic should be thought of as applying not to your return in a single year, but rather to your compound annual growth rate (CAGR), or “annualized” return, over the long run, because in a single given year the swings will be much more wild, and we're investing for the long term here. I won't get into the details of how to think about CAGR here, but suffice to say that it’s more complicated than an average of your return each individual year, because your wins and losses in a given year influence the base from which growth is calculated in the next year. If you invest $1,000 dollars and the market drops 30% in one year, you now only have $700 invested, and need a gain the following year of about 43% the next year just to break even. When the conventional wisdom says that it expects the market to return 6-7% in the long-run, it means an annualized return of 6-7%, not average.
By bringing its rate down to 2.5% last night, Robinhood is now offering a rate that, to my mind, makes sense to take, in expectation, if you think that investing in equities makes sense at all over the long run. It's lower than federally subsidized student loans, it's lower than most mortgage rates, hell it's lower than the rate at which most foreign governments can borrow. If the logic of using margin to buy a broad index of stocks was risky but seemed to have some potential for upside to me at 5%, it seems knock-down obvious to me at 2.5%. You could buy companies that have been around for 130 years that would pay you more than this in dividends.
The rate is so low in fact that we should reflect on whether Robinhood can maintain it, what it tells us about Robinhood's business model, and what it tells us about the stock market in general, especially since the new 2.5% number is notably not pegged to the benchmark rate. At a minimum, it's a bet by Robinhood that interest rates from the Fed will be very low for a very long time. It’s also a piece of evidence suggesting that, thanks to Robinhood's stated aim of democratizing access to financial institutions, retail investors could be a factor in the next financial crisis, perhaps even more so than they were in the dot-com bubble. It might even cause us to zoom out and ask, big picture, whether the Fed's generosity in the variety and riskiness of the asset classes it was willing to backstop during the pandemic has caused stocks to be priced as though they were only as risky as we previously considered debt. Or perhaps technology's advance, bringing down barriers, improving efficiency, automating risk calibration and such, will cause a long-term trend towards lower rates of return, as the economy in general becomes more automated and perhaps (?) less volatile.
Whatever picture this suggests of trends in general, I believe that the specific impacts of competition leading to cheaper margin for individual investors will take some time to propagate. I think that the argument for at least giving the strategy of taking out margin to buy a broad index of stocks a try looks a lot stronger at 2.5% than 5%. At a minimum, you should theoretically be rewarded for being willing to stomach the volatile swings that come with margin year-over-year if you're able to, as this is what will, for good reason, keep many Robinhood users away or cause them to lose a lot of money.
More Risks
Now that I've laid out why I think this should work in the abstract, here's more bad stuff just in case you're the kind of person who's tempted to try it out without thinking it over a lot more.
You could lose a tremendous amount of money for any of a variety of reasons if you do this. You might lose money in the ways people traditionally lose money investing, but just lose a ton more. For example, you get unlucky with investment timing, don’t diversify broadly enough, or the stock market in general collapses. But with margin, there are new and unique ways you can lose lots of money! For instance, even if the market continues to grow, but at a much slower rate than it has up until now, you will lose money. This is a very risky strategy. Let’s try to understand a few of the risks that are unique to investing on margin.
One big reason that individual investors typically avoid using margin, in addition to the high interest rates, is because of the risk of receiving a “margin call”, which is when your broker becomes worried that your equity value in the account is becoming low enough that it no longer serves as a trustworthy source of collateral for their loan. This means one particularly deep loss, say over a single year, could permanently force you off of the strategy.
If you start with our $2,000 account of $1,000 of your money and $1,000 of margin, and then go on to see the assets in your account drop by 50%, your account now only has $1,000 worth of assets in it, which is just barely enough to pay back your loan. Because the broker comes before you every time when you owe them money, the broker will in this scenario issue you a “margin call” which means force you to sell everything in your account so that you can pay them back and not lose any more money. They don’t even have to ask your permission to do this. In practice, they’ll do it well before you even come close to not being able to pay them back. This is especially bad because you’re then effectively getting rid of your leverage when the value of the market is very low. The loss is permanently locked in, and they won’t let you keep playing to see if the market recovers. For this reason, while brokers will legally let you use margin until your equity to margin ratio is 1:1, or “leveraged 2x” as mentioned before, it’s safer to do substantially less than that, perhaps only using margin equal to 30% of your account value.
One of the points above about Robinhood's possible motivations for lowering the rate in the first place also hints at a risk, although it would require its own post to explore in depth. Essentially, the fact that Robinhood is offering margin with interest this low might suggest that they believe the return of the stock market in general will be lower over the coming decades. For kind of complicated reasons, Robinhood offering margin this cheap probably implies that it believes the U.S. Federal Reserve itself is going to offer interest rates that are very cheap for a long time. If the Fed offers cheap interest rates for a long time this should also mean that stocks will have lower returns for a long time. For this reason, it's difficult to interpret a commitment from Robinhood to margin interest rates this low as anything other than a bet that the conventional wisdom of 6-7% returns is going to be sorely disappointed over the coming decades.
Conclusion
In any case, despite the risks of actually executing on this, I think the logic here is worth exploring, especially since it might be the kind of strategy that really will in fact reward you if you're young and can be relied upon to not sell your investments for multiple decades. This might be an instance of competition and technology clearing the way for people willing to accept extreme short-term volatility getting outsized benefit in the long-run.
Acknowledgements
Thanks to Byrne Hobart, Aaron Wolff, and Barry Plunkett for providing useful input on this.