What Brewster’s Millions teaches you about leverage
The 1902 novel by George Barr McCutcheon doesn't just teach investors how to spend money, but how to make it too.
Brewster's Millions is a 1902 novel by George Barr McCutcheonabout Montgomery Brewster, a young man who inherits $1m from his grandfather. However, shortly afterwards he receives an offer from his even richer uncle, who hated Brewster's grandfather.
If he can spend the entire sum within a year, he will give him $7m, but if he fails or refuses he will get nothing. Brewster accepts the challenge, going on a massive spending spree. After many mishaps and adventures, Brewster succeeds in winning the money. The book has inspired several films, most notably a 1985 version starring Richard Pryor.
The key moment
In an attempt to lose money, Brewster decides to buy around $1m worth of shares in a lumber company that his broker (and others) thinks are due for a fall, because of an impending strike and a glut in the market for timber.
He buys them at 10% margin, putting down 10% of their price for an upfront cost of $100,000. However, almost as soon as he buys the shares, he learns to his horror that the strike is going to be called off. This means that the shares end up going up in value by around 6% and he ends up selling them for a profit of just over $58,550.
Lesson for investors
Borrowing money to increase the buying power of your portfolio can boost your returns, provided the asset rises in value by more than the amount of interest that you have to pay on the borrowed money. If Brewster had bought the shares with just the $100,000 down payment he would have made only a relatively small profit of $5,855.
However, his decision to use a high amount of leverage boosted his returns tenfold although in this case a high return was the last thing he wanted, since it made it harder to carry out his goal of burning through $1m.
Other financial wisdom
Brewster's experience illustrates another aspect of investing, namely that when a consensus forms about a stock or a share (either positive or negative) it is more than likely to be wrong. Questioning the market wisdom, or at least having your own independent view, is vital for long-term investing success. It is also a very bad idea to rely solely on the advice of an investment professional, since their views are likely to reflect those of the Wall Street consensus.