The Business of Value Investing.pdf

Establish a Sound Investment Philosophy 63

Scenario 1: After one year, your holdings have declined by 33

percent, so your portfolio is now worth $ 1 million.

Scenario 2: You returns are flat, so your portfolio is worth $ 1.5

million.

Scenario 3: You are up 33 percent after one year, so your portfo-

lio is worth approximately $ 2 million.

Table 4.2 illustrates the net returns in each of the three possible

outcomes. When you have a good year, margin works as it amplifi es

returns, but it has the same effect on losses when performance is

negative or even fl at. However, what you don ’ t see from the num-

bers is the added disadvantages when your performance is nega-

tive. As your portfolio holdings decline, your broker will require

you to sell holdings to raise cash in order to protect the $ 500,000

loan. You have no choice but to sell or to somehow raise additional

outside capital. Most often, the only option is to sell investments,

thereby risking the chance that you are selling a security that was

initially bought at an undervalued price at an even lower and more

attractive price. Making matters worse, should the same security

later have a price rebound, your lack of capital prevents you from

participating from the upside. All in all, the juiced losses coupled

with the loss of control when using margin far outweigh the ben-

efi ts of juiced returns.

Table 4.2 Pitfalls of Margin Use

Scenario 1 Scenario 2 Scenario 3

Starting capital $ 1,500,000 $ 1,500,000 $ 1,500,000

Ending capital $ 1,000,000 $ 1,500,000 $ 2,000,000

• Less margin $ 500,000 $ 500,000 $ 500,000


• Less cost of margin $ 30,000 $ 30,000 $ 30,000
  Net equity capital $ 470,000 $ 970,000 $ 1,470,000
  Total gain/loss (53%) (3%) 47%

CH004.indd 63CH004.indd 63 9/2/09 7:06:53 PM9/2/09 7:06:53 PM