You've discovered the world of Beating the Dow and you feel comfortable investing in the world of solid blue-chip stocks. You love the idea of only spending 30 minutes a year managing your portfolio. And you're thrilled that the approach has had only 2 losing years in the last 22. But you're feeling the itch to get a little more aggressive. That 20.6% compounded annual average return just isn't enough. What do you do? Turn to growth stocks? Maybe. Or options or hog futures? Ack!!!
Well, if you don't want to shift strategies, there's still one option you might want to consider. And like all more aggressive strategies, it bumps up the risk factor slightly. Nevertheless, you might want to consider continuing with your Beating the Dow strategy but adding a little leverage by purchasing a small percentage of your portfolio on margin.
Buying on margin simply means you're borrowing money to buy stock from your broker and you're agreeing to pay the money back with interest when you sell the stock. The current regulations allow you to buy up to 50% of your investment on margin, but that's quite a bit riskier than most Fools would consider. If your stocks drop below a certain threshold, you'll have to put more money in your account or sell some stock to cover that dreaded margin call from your broker. You can greatly reduce the risk of getting a margin call, however, if you're conservative about the use of margin.
Let's look at how a modest use of margin would have helped the returns on a basic Beating the Dow five-stock portfolio over the last 22 years. A $10,000 investment in the basic BTD approach at the beginning of 1973 would have been worth roughly $614,000 at the end of 1994, an average annual return of 20.6%. Now let's add a little leverage and see what happens.
Suppose you invested the same $10,000 and decided to buy 10% more stock than you had cash for. (That represents using 9.1% margin. In other words, 90.9% of the money invested is yours and 9.1% is borrowed.) You borrow an additional $1,000 from your broker at the margin rate (the current broker's call rate is 7.5%) and invest the $11,000 in your Beating the Dow stocks. In 1973 (our first year in the example), your portfolio would have returned 19.64%, giving you a balance of $13,160. (For the purposes of the example, we'll assume you settle up on your entire margin balance once a year. In reality you would do it stock by stock as you sell those positions.) You then repay your broker the $1000 you borrowed plus the $75 you owe in interest and you're left with a balance of $12,085. That's a 20.85% gain on your $10,000 when your portfolio return was really only 19.64%. Pass that hot sauce, please!
Of course, in years when your portfolio doesn't perform better than the interest rate you're paying your broker, your returns slide in relation. However, with a system like Beating the Dow, which has a tremendous decades-long history, the odds are greatly in your favor. How did the margined portfolio perform for the rest of the 22 years? At the end of 1994, your original $10,000 would have grown to $755,000. That's only a single percentage point higher each year than the straight Beating the Dow performance (21.7% versus 20.6%), but the dollar difference between the two portfolios is over $140,000.
How much margin should you use? Up to 20% margin seems a conservative range for a strategy like Beating the Dow. Using 20% margin means borrowing an additional 25% of the money you're investing. (80% of the total invested would be your principal and 20% would be borrowed.) Using that 20% margin for our BTD example, the approach would have returned an average annual gain of 23.4%, bringing the $10,000 investment to just over $1 million after the 22 years.
Keep in mind that margin investing is aggressive and it does increase your portfolio's risk. But harnessed in a Foolish way with a proven strategy, it may allow you to increase your returns within a framework you're already comfortable using. It might just keep you out of those commodity pits too!
Transmitted: 95-09-22 10:20:27 EDT