Getting Sidelined by Margin

Renowned economist Paul Samuelson once quipped that “Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.” This has stuck with me since hearing it years ago as one of the things that makes investing so darn hard for the masses but so profitable for brokerage firms.

We’re wired to want to feel good about what we’re doing, to feel validated in our decisions, and to get that sense of instant gratification. We invest a dollar, pull the lever, and want the noise and blinking lights to tell us we did the right thing. Casinos know this, of course, and that’s why they’re so profitable. They know how to push our buttons to keep us coming back for more.

Like any game, playing is harmless when the stakes are low and the rules clear. But start adding zeroes and complexity, and the situation quickly gets serious and shouldn’t be treated as a game. Or at least understand it’s a different type of game and play it the right way.

Different industries engage in so-called gamification and brokerage firms have built entire business models around it. Robinhood is the clearest example of this. The firm developed a phone app that gave its customers all the flashing lights and other forms of validation they require, even raining digital confetti at certain milestones. (The firm recently stopped the confetti thing since it was getting them into hotter water with regulators.) But one of many problems with this is that Robinhood customers aren’t playing slots while enjoying free drinks, they’re investing in complicated markets and in complicated ways, including being incentivized to buy more stock with borrowed money without fully understanding how it works.

Using borrowed money to buy assets is something we do all the time. Think of the mortgage on your home. You put down maybe 20% and borrow the rest to purchase a relatively stable asset. You usually get clear terms, like a fixed payment for 30 years and have disclosure documents that show how much interest you’ll pay over the life of the loan. If the value of your home drops, just keep making your mortgage payments and nobody will kick you out, and so forth. That’s a good use of leverage and the mechanics are easily understood.

But then we get to a form of leverage available in brokerage accounts referred to as “buying on margin”. Using margin magnifies gains when times are good but can also lead to catastrophic losses when markets turn. This can be sort of like the initial excitement of pouring gasoline on a campfire that then spreads to melt your tent. Margin gets incredibly complicated and should only be for seasoned investors who know (or at least think they know) what they’re getting into and can afford the risk.

The reason is that margin, at its simplest, is a loan with terms meant for short-term trading, not long-term holding as with your mortgage. This can come back to bite investors when stock prices are volatile. The stocks in your portfolio act as collateral for the loan and can only fall by a certain amount (which is set by government regulators) before you’re “called” and must deposit cash to make up for the decline. If you can’t afford that you’re forced to sell stock, something that usually catches investors unawares. That old saying of “when it rains it pours” is never more apt then when investors are forced to sell stock in a down market to meet their margin requirements. This can leave the uninformed and unprepared in a state of utter bewilderment, wondering where all the money just went.

This has been the unfortunate reality for many Robinhood customers in recent months. The firm made it far too easy to buy stock on margin. Just a few clicks and that was it. Yes, they provided disclosures, but I seriously doubt most customers read them. And why should they have? Investors were receiving lots of validation from Robinhood and social media, and stock prices were mostly going up. In short, it felt great for a while until it didn’t. I repeat this all the time, but it’s just like an adult version of musical chairs. The music stops suddenly and only then do you truly realize the risk you were taking. Maybe investors should be required to play the game before being given access to margin; sort of like having teens wear those goggles that simulate drunk driving. It might be instructive.

I’m attaching a link to an article from The Wall Street Journal that ties all this together. It’s a sad commentary on how far things have gotten with gamifying the investing process. I suggest you send it to anyone in your life who might be getting into day-trading or using margin. If nothing else, perhaps it will jar them into getting better educated on how to play the game the right way.

The Journal has a soft paywall so let me know if you can’t access the story and I’ll email it to you through my subscription.

Have questions? Ask me. I can help.

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