The Daily Dow
Tuesday, June 24, 1997
by Robert Sheard
LEXINGTON, KY. (June 24, 1997) -- Any time the stock market enjoys a relatively strong period of growth (as it certainly has for the last few years), investors anxious to take advantage of the economic nirvana as fully as possible will look for ways to improve on the downright dull Dow Approach. Many such attempts, though, are misguided -- resorting to options and the like.
If you really want to juice up your Dow Portfolio, my favorite method is to use a consistent, but relatively conservative amount of leverage (borrowing money from your broker on margin and then investing it in the stocks you're buying already).
Let's look at a hypothetical situation to show how margin can boost your returns without adding to your cost of trading or increasing your risk inordinately. First the assumptions: we'll assume a constant rate of return on your portfolio of 18%. It's probably a conservative estimate since the actual returns for the Foolish Four have been over 20% for the last several decades, but no matter. Let's just focus on how margin changes the equation.
Let's also assume a constant margin interest rate of 7% (chosen simply because that's what I pay today). I haven't included any allowance for taxes, so if you're concerned about their effects, just adjust the other variables as you see fit. The real point I want to make is that if you're consistently achieving returns in excess of the margin interest rate you must pay to borrow from your broker (as the Dow Approach has done for decades), then a bit of leverage can work for you nicely.
Back to the example. We'll start with $20,000 and borrow another 25% ($5,000). You can borrow up to 50% of the total investment, but that's stretching the safety envelope further than I'd like to go. Borrowing 25% more than you already have means 80% of your total portfolio is yours and only 20% is on margin. That's the most I've ever done and probably the most I'll go in the future. That level keeps the risk of ever having to shell out extra money to answer a margin call from your broker pretty remote.
So in year one we're going to invest $25,000 in the Dow stocks, returning 18%. At the end of year one, the portfolio is worth $29,500. After paying back the $5,000 loan and the interest ($350), the total portfolio value is $24,150. Suddenly that 18% gain has been stretched to nearly 21%. Carry out the same process year after year, borrowing 25% of your portfolio value each year.
Jump ahead 30 years and this simple process has carried your original $20,000 investment to a total portfolio value of more than $5.7 million! If you invested it in the straight approach without the leverage, the return is still impressive, but your portfolio only grows to $2.9 million after 30 years. By using a consistent level of margin leverage with a solid program like the Dow Approach, our sample portfolio is worth nearly twice as much as the straight approach. No extra trading is required. No extra research is required. You don't have to hunt for small-cap volatility to juice up your portfolio. And maintaining a margin balance means you can add new money to your portfolio regularly without having to rack up more commissions; the new money just pays off a portion of your balance while your money has already been at work in the Dow stocks.
A final word of caution: Using leverage does magnify the movements of your
portfolio, but that can work both ways. When the market goes down, your loss
is exaggerated just as your gains are exaggerated when the market goes up.
Don't turn a useful tool into a gambling vehicle.
(c) Copyright 1997, The Motley Fool. All rights reserved. This material is for personal use only. Republication and redissemination, including posting to news groups, is expressly prohibited without the prior written consent of The Motley Fool. ________________________________
Stock Change Last -------------------- T + 11/16 36.94 GM +1 1/2 56.75 CHV +1 1/2 74.25 MMM + 15/16 100.94
Day Month Year
FOOL-4 +1.84% 3.42% 3.87%
DJIA +2.02% 5.82% 20.31%
S&P 500 +2.02% 5.67% 21.01%
NASDAQ +1.26% 3.72% 12.50%
Rec'd # Security In At Now Change
1/2/97 120 3M 83.00 100.94 21.61%
1/2/97 153 Chevron 65.00 74.25 14.23%
1/2/97 179 Gen. Motor 55.75 56.75 1.79%
1/2/97 479 AT&T 41.75 36.94 -11.53%
Rec'd # Security In At Value Change
1/2/97 120 3M 9960.00 12112.50 $2152.50
1/2/97 153 Chevron 9945.00 11360.25 $1415.25
1/2/97 179 Gen. Motor 9979.25 10158.25 $179.00
1/2/97 479 AT&T 19998.25 17693.06 -$2305.19
CASH $609.53
TOTAL $51933.59