Thursday, November 20, 1997

The Daily Workshop Report
by Robert Sheard (TMF Sheard)

In the past I've discussed using margin leverage to boost returns and/or as an easy way to add new money to a portfolio regularly without racking up lots of costs. (You borrow conservatively from your broker at the beginning of your annual cycle, invest the total, and then let your monthly savings deposits pay off the margin balance.)

A point I haven't discussed, though, and should have, is the risk of getting a margin call from one's broker. A margin call, if you're not sure, occurs when your equity in the total portfolio value slips below the limit set by your broker.

For example, my broker requires that my portion of the total portfolio (my equity) remain above 30% of the total portfolio value. If it falls below that, I'll get a margin call requiring me to add new money or to sell some shares and pay back at least a portion of the margin balance. As margin calls are triggered by the portfolio going down, having to sell out at such a time is a double whammy.

In my discussions of margin investing, though, I've always suggested a good ceiling on margin leverage is 20% of your total portfolio. So let's see how far your total portfolio would have to fall before a margin call would be triggered.

If your portfolio value is worth $10,000 and you borrow an additional $2,500, you're going to be investing $12,500. Of that amount, 80% is your own cash and 20% is what you must repay your broker. Let's say your portfolio tumbles. You still have to pay the broker that $2,500 (plus interest) so the losses are coming out of your own equity.

But to sink low enough that your equity is only 30% of the total, your $12,500 total investment would have to drop all the way to $3,571, more than a 71% loss. At $3,571, your equity of $1,071 would be 30% of the total value. With the Dow Approaches, of course, the odds of a 71% loss are right up there with the odds of me beating Tiger Woods in match play, straight up. It could happen (if he dropped all his clubs off a cliff by accident), but I wouldn't hold my breath for it.

At higher margin percentages, though, the risk of triggering a margin call increase. For instance, if you borrowed the maximum allowed, 50% on margin, you could trigger a margin call if your portfolio dropped only 28.6%. In the crash of 1987, for example, that was a very real possibility.

Here are the numbers for such a scenario. If you start with $10,000 and borrow another $10,000 (50% of the total on margin), the $20,000 would have to drop to $14,285 to trigger a margin call. At that level, your equity would be worth only $4,285, which is 30% of the $14,285.

Margin calls, then, are always a risk for really aggressive investors who are heavily margined. But the risk of getting such a call when you're using a conservative level of margin leverage (20% or so) is greatly reduced, especially with fairly stable stocks such as the Dow stocks. As always, if you're considering margin, read the fine print from your broker to be sure you understand all the possibilities. Fool on!

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