The Dow Approach
The Dow Approach
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FOOL GLOBAL WIRE LEXINGTON, KY. (Feb. 20, 1997) -- A number of readers pop into the Dow area periodically and want to know what I think of using options, especially long-term options (LEAPS) to spice up the Dow Dividend Approach. My standard answer is always that I have no experience with options, and what little I do know about them suggests that most of us are better off staying away. There are undoubtedly some terrifically wealthy options traders, but I'd guess there are dozens of hard-luck stories for each one of them. They're just not the odds that excite a Fool. Someday I'll find the time to study them more carefully so I can't continue to plead ignorance, but for now, it works for me! But that doesn't mean I'm adverse to a little spicy cooking, though. I've written in the past that an easy way to spice up the otherwise dull-as-watching-the-dryer-spin Dow Approach is to use a little leverage. Harvey Knowles and Damon Petty mention the use of margin in their book, The Dividend Investor, and I agree with their general premise that a conservative level of margin investing over the long haul can add value to the Dow Approach. Let's look at how it works. Let's start with a $25,000 portfolio. We'll use the long-term growth rate of 23% for the Foolish Four and Unemotional Value approaches. And we'll assume a margin interest rate (the rate you pay the broker to borrow money) of 8%. And of course, that pesky tax rate of 28%. The current regulations allow you to borrow up to 50% of your total investment. That is, if you're investing $50,000, then you have to put up at least $25,000 of that total. The margin requirements historically have been much looser at times than what we have now, but margin abuses are often considered one of the many causes that led to the great crash some seven decades ago. My belief is that if you keep your margin borrowing under 20% of your investment total, you're not likely to get that dreaded margin call (where your broker sends Guido to your door looking for more money). Back to our example. You have $25,000 and you borrow another $6,250, giving you $31,250 to put into your Dow stocks. With a 23% return, your capital gain is $7,188, giving you a total of $38,438. To pay off the margin amount, you give back the $6,250 that you borrowed, plus $500 for the 8% interest. That leaves $31,688. Paying the long-term capital gains on $7,188 means you give Uncle Sam $2,013. Your grand total after year one is $29,675. That represents an 18.70% after-tax-and-margin-fee return. Without using the borrowed funds, your return starting with the same $25,000, the same 23% return, and the same 28% tax rate, is 16.56%. Your $25,000 grows to $29,140. That difference of $535 between the two portfolios doesn't sound like much, but if you begin to compound the difference over many years, it can make a sizable difference. After 25 years without using any margin borrowing, the $25,000 initial investment would grow to $1.15 million after taxes. That same initial investment, invested exactly the same way, but adding 20% margin, would grow to $1.82 million, after taxes and margin fees. A $670,000 bonus using exactly the same strategy is pretty attractive, I would think. A cautionary note, though. Leverage is wonderful when your portfolio is going up, but the same exaggeration of your returns works on the downside as well. If you aren't willing to take the losses as well as the gains on margin, don't take on the added risk. But with a long-term reasonably stable approach like the Dow Dividend strategies, modest margin investing presents an opportunity to spice up your returns without having to adopt a more aggressive stock-picking strategy. Another advantage of margin investing is that it takes away that pesky problem of what to do with dividends or how to add new money to the market as a periodic savings tool. If you have a margin balance, your dividends and new cash are put to work immediately in that they pay back portions of your margin loan. |
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