Tuesday, February 24, 1998

The Daily Workshop Report
by Robert Sheard (TMF Sheard)

LEXINGTON, KY. (Feb. 24, 1998) -- In last night's Evening News, Jim Surowiecki examined the risks inherent in using margin leverage. And while I agree with Jim for the most part, I think it's important to quantify the actual risk involved in using a reasonable amount of margin leverage, such as I've been discussing in the Workshop for some time.

Jim made a reference to the market crash of 1929. I have a problem with any such comparison, if for no other reason than the markedly different rules for margin. As Jim pointed out, in 1929, speculators (and you can't call them investors) could buy a dollar's worth of stock by only putting up a dime of their own money. It should be obvious that such a temptation would turn any market into a highly speculative one -- not an investor's market at all.

I believe that even today's much more stringent requirement requiring investors to put up fifty cents for every fifty cents they borrow is too lax. But it's at least helped create a world of difference from 1929's market culture.

That aside, I've argued that Foolish investors can reasonably invest up to 20% on margin without taking on undue risk. So let's look at the actual dollar risks involved with such a level of margin.

If you have an $80,000 portfolio and you borrow an additional $20,000 on margin, you're investing a total of $100,000. Of the total, 80% is your own capital and 20% is owed to your broker (plus interest). This is considered to be 20% on margin and is only 40% of the maximum allowed margin level.

Each broker has a different equity requirement, but since my broker's requirement is 35%, I'll use that for the example. You might find some brokers with even lower equity requirements. This means that the portion of the total amount invested that I own must remain above 35% or I'll get a margin call telling me either to sell some stocks and repay a portion of the loan or add some new capital. The margin call is the big fear used in arguments against margin.

But what would it actually take to trigger such a margin call? Let's look. The $100,000 investment in my example would have to plummet to $30,769 before my equity portion would slide below the 35% threshold required by my broker. In other words, using 20% margin leverage, I won't get a margin call unless my overall investment loses 69% of its original value.

I don't know what the mathematical odds are of such a drop occurring, but for a well-diversified portfolio, especially one comprised of large caps like the Dow and Keystone stocks, I have to say that a margin call at that stage would be low on my list of things to worry about. It's always a possibility, of course, but such a mammoth drop is unlikely enough that I believe the advantages of such a level of margin (even used mechanically at all times) are worth the risk.

Let's look at the advantages. Margin interest rates right now can be had for roughly 7% at some brokers. Even an S&P 500 Index fund investment is likely to out-pace such a cost, so the borrowed money, on average, will boost your returns as long as your gains are better than 7%. In addition, the margin interest you pay the broker is a deductible investment expense. And finally, if you add money regularly to your portfolio, having a conservative margin balance makes investing new money a snap. Your monthly or quarterly deposits simply pay down the margin balance while the money you're adding is already at work for you in the market. You don't have to worry about running up extra commissions and deciding what to buy each month. The money has already been invested since your last update.

So I disagree with Jim that the use of margin is antithetical to patient and disciplined investing. In fact, I'd argue that just the opposite is true. If I'm using the Dow Approach and averaging 18% returns but enticed by the lure of higher gains in riskier stocks, I can achieve those slightly higher returns by using a little margin leverage without taking on the added volatility of heading for smaller and more volatile stocks. That 18% Dow return suddenly becomes a 20.75% return using 20% margin at a 7% interest rate. And close to three percentage points a year, compounded over a couple of decades, can make a huge difference. Put $25,000 away and earn 18% for 25 years and you have $1.57 million at the end. But if you buy the same stocks and add 20% margin, your retirement fund equals $2.79 million after 25 years. That's a heck of a difference without going anywhere near the maximum margin allowed by current SEC rules.

So for a consistently strong approach like the Dow Dividend Approach, or the large-cap Keystone stocks, or even a simple S&P 500 Index fund, a conservative level of margin doesn't add outrageous risk or turn one into a Vegas-style gambler. It's a reasonable way to boost your returns without taking on undue risk.

Of course, if you start getting greedy and pushing the envelope on your margin balance, your risk increases rapidly. By the time you're fully margined, a margin call then becomes a real possibility in any significant market downturn. A 23% loss would trigger a margin call if you're fully margined and your broker has a 35% equity requirement. So, look at the risks of margin, but also consider the benefits if you're prudent with the level of margin you employ and the kinds of stocks you buy. It can be a very powerful tool in your favor if used carefully. Fool on!

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