The Daily Workshop Report
by Robert Sheard (TMF Sheard)

LEXINGTON, KY. (Nov. 13, 1997)

I've written about the effects of investing on margin a number of times and, of course, such scenarios always include a certain measure of speculation, both about portfolio returns and margin interest rates charged by one's broker. But a number of readers have asked me about the mechanics of margin itself and how one might go about using it (conservatively) as an aid in a regular savings plan.

So let's ignore predictions on returns today and focus simply on the "how-to" of saving regularly using conservative margin leverage amounts.

Our model saver/investor, Tony the Timely, currently has a common-stock portfolio worth $25,000 and he sets aside a regular percentage of his pay each month for investment. After funding his IRA and his company 401k to the extent that his employer matches his funds, Tony still has $350 a month he'd like to invest in his taxable account, but he doesn't want to pile up commission fees each month or run three or four different groups of stocks using staggered starting dates. He also doesn't want the money parked in a money-market fund or even an index fund while he waits for his annual portfolio adjustment to roll around. He wants the new money each month to get to work for him immediately, but cheaply and easily.

Here's what Tony might do as an alternative plan. Since over the next year, Tony will be investing an additional $4,200 ($350 each month), he might consider borrowing the $4,200 at the beginning of the year and investing it along with his own $25,000. He'd be investing a total of $29,200, of which just over 14% would be borrowed directly from his broker. (Any time you keep your margin balance under 20% of the total invested, you are reasonably protected against a market call during a bad patch for the market. Starting out with only 14% on margin, Tony's added risk in using margin leverage is minimal -- and it shrinks every month as he pays down the balance with his additional savings.)

Each month as Tony sends his monthly check to his broker, that $4,200 loan is gradually paid off automatically. In addition, Tony's quarterly dividends are also put to work immediately paying off the debt. While this is going on, that $4,200 is already at work in Tony's stock portfolio. So by the end of the year, when Tony's annual portfolio adjustment rolls around, his margin balance has been completely paid off, he's only had to make one set of stock purchases all year (and pay one set of commissions), the margin interest he paid to the broker each month can typically be deducted on his taxes, and for the entire twelve months Tony has had his year's worth of savings already at work in the market.

So if you add money regularly to your portfolio but want a convenient way to do it, consider a very conservative level of margin leverage. Over the long run, it can also boost your returns a little bit if your stock portfolio gains are higher than the interest rate you pay your broker for the loan. For example, if you're paying 7% in interest to your broker while that borrowed money earns you 15% in the market, you've boosted your total return. (Shop around for margin rates and read the fine print from various brokers. Many of them stick it to investors who borrow only small amounts with pretty high rates. Find a broker whose margin rates don't penalize the conservative margin user.)

As with any other powerful financial tool, margin can be abused. The exaggeration you see in your returns when leveraged goes both ways. Don't get greedy and margin your portfolio to the maximum, praying you'll hit the jackpot just this once. But if you use margin conservatively because you save regularly and can cut your transaction and accounting costs by doing so, it's a good use of limited debt -- a debt you know you're going to be paying off within a year with added savings, and also one for which it is likely you'll have something to show for after the year's up (a higher net worth). I use this plan regularly and it's worked wonderfully for me. Fool on!

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