Wednesday, April 7, 2021

Warren Buffett and Charlie Munger on Leverage

Warren Buffett and Charlie Munger need no introduction. If you do, please check the Wikipedia entries for each fellow.

I am a big fan of both gentleman, and have been going through old annual reports, speeches and meeting transcripts and interviews to learn more from them about business, investing and life.

They are amazing at summarizing complex financial topics into a few paragraphs that could be understood by anyone.

As both of them has been investing for decades, they have a ton of experience and insights that we can all learn from.

One topic I recently discussed involved short selling. Another one is leverage, or the use of borrowed money to buy securities.

Warren has spoken about the dangers of using leverage. 

He has said the following about Long Term Capital Management, the hedge fund ran by Nobel Prize Laureates and PhD’s, which blew up in 1998. It turned out it was heavily leveraged.

"But to make money they didn’t have and didn’t need, they risked what they did have and did need. That is foolish. That is just plain foolish. It doesn’t make any difference what your IQ is. If you risk something that is important to you for something that is unimportant to you it just does not make any sense."

“If you’re smart you don’t need leverage; if you’re dumb, it will ruin you.”

It is crazy in my view to borrow money on securities. It’s insane to risk what you have and need for something you don’t really need… You will not be way happier if you double your net worth.

Leverage can magnify returns if you are right, but it can also lead to ruin if you are wrong. If you invest smartly you don’t need the leverage to begin with. And if you do use it, watch out below. 

Charlie Munger is also not a fan of leverage:

We’re just not interested in taking a substantial chance of taking a lot of very decent people back to “Go” so we can have one more zero on our net worth.

Buffett has quoted Charlie on leverage as well “My partner Charlie says there is only three ways a smart person can go broke: liquor, ladies and leverage,” he said. “Now the truth is — the first two he just added because they started with L — it’s leverage.”

This interview with Buffett, summarizes his thought process on using leverage when investing in equities.

Buffett has also discussed leverage in more detail during a 1998 speech at Florida University. I have posted the transcript portion that discussed Long-Term Capital Management, the hedge fund that used excessive leverage, and lost almost all money during the summer of 1998, when Russia defaulted on its debt. While history doesn't repeat, the recent news of investor Bill Hwang who used excessive leverage and blew up recently is a stark reminder that smart people should not be using leverage: (Source for Transcript)

The whole Long Term Capital Management – I hope most of you are familiar with it – the whole story is really fascinating because if you take John Meriwether, Eric Rosenfeld, Larry Hillenbrand, Greg Hawkins, Victor Haghani, the two Nobel prize winners Merton Scholes… If you take the 16 of them, they probably have as high an average IQ as any 16 people working together in one business in the country, including Microsoft or where ever you want to name. So an incredible amount of intellect in that room. Now you combine that with the fact that those 16 had had extensive experience in the field they were operating in. These were not a bunch of guys who had made their money, you know, selling men’s clothing and all of a sudden went into the securities business. They had in aggregate, the 16, probably had 350 or 400 years of experience doing exactly what they were doing. And then you throw in the third factor that most of them had virtually all their very substantial net worths in the business. So they had their own money up. Hundreds and hundreds of millions of dollars of their own money up, super high intellect, working in a field they knew, and essentially they went broke. That to me is absolutely fascinating.

If I ever write a book it will be called “Why Smart People Do Dumb Things”. My partner says it should be autobiographical. But this might be an interesting illustration. These are perfectly decent guys. I respect them and they helped me out when I had problems at Salomon. They are not bad people at all.

But to make money they didn’t have and didn’t need, they risked what they did have and did need. That is foolish. That is just plain foolish. It doesn’t make any difference what your IQ is. If you risk something that is important to you for something that is unimportant to you it just does not make any sense. I don’t care whether the odds are 100 to 1 that you succeed or 1000 to 1 that you succeed. If you hand me a gun with a million chambers in it, and there’s one bullet in a chamber and you said, “Put it up to your temple. How much do want to be paid to pull it once,” I’m not going to pull it. You can name any sum you want, but it doesn’t do anything for me on the upside and I think the downside is fairly clear. So I’m not interested in that kind of a game. Yet people do it financially without thinking about it very much.

There was a lousy book written once with a great title by Walter Gutman. The title was “You Only Have to Get Rich Once”. Now that seems pretty fundamental doesn’t it? If you got $100 million at the start of the year and you’re going to make 10% if you are unleveraged and 20% if you are leveraged 99 times out of a 100, what difference does it make at the end of the year whether you got $110 million or $120 million? It makes no difference at all. I mean, if you die at the end of the year, the guy who writes the story might make a typo and he may say 110 even if you have 120. You have gained nothing at all. It makes absolutely no difference. It makes no difference to your family. It makes no difference to anything.

Yet, the downside, particularly managing other people’s money, is not only losing all your money, but it’s disgrace, humiliation, and facing friends whose money you have lost. I just can’t imagine an equation that makes sense for. Yet 16 guys with very high IQs, who were very decent people, entered into that game. You know, I think it’s madness. It’s produced by an over reliance to some extent on things. Those guys would tell me back when I was at Salomon, “A six sigma event wouldn’t touch us. Or a seven sigma event.” They were wrong. History does not tell you the probability of future financial things happening. They had a great reliance on mathematics. They felt that the beta of the stock told you something about the risk of the stock. It doesn’t tell you a damn thing about the risk of the stock in my view. Sigma’s do not tell you about the risk of going broke in my view and maybe in their view now too.

But I don’t even like to use them as an example because the same thing in a different way could happen to any of us probably, where we really have a blind spot about something that is crucial, because we know a whole lot about something else. It is like Henry Kauffman said the other day, “The people who are going broke in this situation are of two types, the ones who knew nothing and the ones who knew everything.” It’s sad in a way.

You do not want to risk everything, merely to have a higher net worth, when that additional net worth won’t improve your standard of living markedly. And if you lose it, your standard of living would be markedly downgraded.

I believe investors should not be in a hurry to get rich quickly, but to enjoy the journey. After all, it usually can take 10 - 15 - 20 years of meticulous saving and smart investing to reach financial independence. There are no shortcuts in investing. While taking on leverage may seem like a way to speed up the journey in some cases, it also exposes the investor to other risks and may cause them to worry about stock price fluctuations, instead of taking advantage of them.

I have used leverage in the past, and generally made money doing it. I used somewhere between 10% - 20% margin, using low cost broker Interactive Brokers

In other words, if I had a portfolio worth $100,000, I would buy $25,000 worth of stock on margin. If my average yield was 3%, and the cost to borrow was 2%, I would essentially increase my dividend income from $3,000 to $3,750, before deducting $500 for interest. My dividend income alone would pay off the margin within a few years, without even considering the impact of dividend increases.

If stocks fell by 50%, that means that the portfolio is worth $62,500, but has $25,000 margin loan against it. That's now a 40% margin. The friendly broker may tighten margin requirements, and start selling your stock to protect themselves. With margin, you are exposing your portfolio to additional risks, namely the risk that a falling stock price may cause you to sell, which is the opposite of what an intelligent investor does. Callable leverage is dangerous, as it increases the requirements on your end, the moment your positions are going against you.

The problem is that brokers do not want to let you have too much borrowed money. If falling stock prices caused the value of my portfolio to fall below a certain amount, I could face a margin call, and the broker would sell my stock. If the stock recovered, I would have ended up trading my my long-term advantage of being a patient long-term investor who can weather any turbulence in the markets and the economy, merely to increase my income by a few basis points. Margin can turn my advantage into a disadvantage.

When I buy a stock, the most I can lose is 100%. If I buy a stock on margin however, my theoretical losses can be higher than 100%, I am margined to the tilt, and if that stock gaps down and the broker is unable to sell it quickly enough. You can also lose money on margin if a stock falls down enough to trigger a margin call, and then bounce back. As we know, stocks do not go up or down in a straight line. The prices oscillate wildly above and beyond what a reasonable business analyst would estimate for their fair value. Dividends on the other hand are much more stable, because they are derived directly from fundamentals. Unlike prices, which are someone's perceptions on what the fundamentals are going to be, dividends are actual fundamental evidence.

When I used margin, I realized that when stock prices went down, I started wondering whether new cash contributions should be used to cover margin or buy more stock. So I gradually used dividends to pay off my margin loan, and stopped doing margin. I also realized that a 10% or 25% margin is not really going to increase my future returns that much, so the risk was not worth it for me. If you decide that you want to try margin, I would try to read up as much as possible on the topic first, and consider the any other risks out there that I have missed. The interesting fact is that using margin made me much more emotional about the ups and downs of the stock market. In other words, I was listening to the manic-depressive Mr Market, instead of ignoring him, unless he offered me an opportunity I cannot resist. Most folks feel safe to use margin when stocks are high, and may be at risk of a correction. If they panic when stocks have that correction, since their losses are amplified by the amount of borrowed money, they may end up buying high and selling low.

At the end of the day, I believe that the quest for financial independence or retirement is a journey that needs to be enjoyed, not a destination. There are no shortcuts to reach your goals and objectives. It takes time, patience, perseverance and focusing on things within your control to reach those goals. Do not be in a hurry to get rich quick. Taking unnecessary risks may actually increase the risk of never reaching the end goal or reaching it at a slower pace, if you get lost along the way. 

In addition, I believe that you only need to get rich once. The habits you formed on your quest to reach your financial goals should hopefully carry you for the next phase of your journey. Which is why I believe that margin is to be avoided.

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