Using existing capital to buy finance for your portfolio
Imagine knowing that you will buy shares of a company like US Bancorp or Wells Fargo. You owe it for some big cash returns such as bonus, inheritance or real estate proceeds.
As you wait for these funds, the stock market crashes and you find yourself, after careful analysis, come to the conclusion that the action you are interested in is cheap; dirt cheap.
What to do? Wait, and hope for the same (or lower) price, considering the risk of sitting on the sidelines to miss the opportunity to buy at an attractive price?
Support a particular debt or liability
Not necessary. In the case of professional investing, there is a term known as a cash transfer. These are the cash flow requirements necessary to support a particular debt or liability.
Money transfer essentially facilitates the purchasing power of the margin to fund the purchase of those shares without introducing high risk. There are usually three important ingredients for creating a cash transfer concept for you. Let’s examine each one.
What are the benefits?
In order to benefit from financial aid, you must have other investments or funds that you can borrow from
Let me say it again since I have many times on the site, this is usually marginal debt extremely risky for average investors as it can cause small changes in market prices to erase all their equities, leaving them to shatter and, in some cases, forced to declare bankruptcy because they cannot fulfill their obligation to the brokerage house.
Here’s an example of why: Imagine having USD 50,000 in your brokerage account, all of which is invested in blue-chip stocks. All else being equal, you can borrow a maximum of USD 50,000 against these securities, so you end up with USD 100,000 worth of stock and 50,000 debt margins against them at an interest rate set by your brokerage or financial institution.
You will never want to push your maximum purchasing power, as your stocks can fall by 10% if corrected. On a USD 100,000 portfolio, that’s USD 20,000 – or 20% of your USD 50,000 capital thank you (or not, thank you, in this case) for using 2-1 leverage.
That means your capital will fall to USD 30,000, while your debt margin will be USD 50,000. It is very possible to get a call from your broker who will tell you to deposit additional funds immediately or will sell stocks in your account to pay off as much of their debt as possible. In many cases, this can trigger a capital gains tax, which makes the situation worse. That brings us to our second point.
Borrow the maximum amount
Leave a large margin of safety so you will not be subject to a marginal call even if the 1987 accident happens without warning
The general rule of thumb, which is still aggressive for the average investor, is the 2/3 rule. Basically, take your balance, in this case, USD 50,000, and divide it by .67 – in our example, the result is USD 74,626. Now take that amount and subtract your capital (USD 50,000) and end up with USD 24,626. This is the maximum amount you could borrow assuming stock prices are reasonable and you do not expect big financial shocks.
Another acceptable metric function is the more conservative 3 / 4th rule, simply substituting .75 for the .67 variable in the formula. In this case, you will end up with one shame of USD 16,700. Only you and your financial advisor can determine what is the best course of action based on your specific goals and circumstances.
Stock (or other assets) should generate large amounts of cash relative to cost
In the case of common stock, you will want a nice, safe, thick dividend yield. Using our US Bank example, you could buy USD 24,626 worth of stock in the margin over your USD 50,000 balance sheet value.
The stock reaches about 4.5% or about USD 1,108 in the first year. If your debt margin was 8.5%, your first interest expense would be approximately USD 2,100. If the stock had not paid dividends, this entire amount would have been added to your debt margin, which would have brought it to USD 26,726 within twelve months of purchase.
Still, along the way, those dividends would pop up, reducing the cost of carrying the debt. In this case, the total cost would almost be cut in half, leading to an increase in the margin debt to just USD 25,618 compared.
This adds to the margin of safety and if you are able to make the USD 992 difference, your margin balance would remain USD 24,626 – the cost of the stock.
In the meantime, over the next few years, the value of those stocks should (hopefully) increase and in the meantime you will receive your contingency, allowing you to pay off the balance.
Caution! This is not a proper technique for most investors!
Unless you are financially secure, able to meet potential margin calls, have a significant margin of equity in the form of a capital balance as a percentage of your total debt margin, and are absolutely convinced by a conservative and professional analysis of SEC filings and other documents that you have found a stock or property which may be undervalued, and you expect the cash to pay off your overall balance, this technique is probably very unsuitable for you.
Don’t try it unless you fill out this description and the skilled, well-respected money manager you work with believes it is right for you.