Tuesday, 18 November 2014

Using leverage in a bull-market

In a bull market, a lot of people get enticed to use leverage to enhance their portfolio returns. Leverage comes in many forms, loans using existing stock as collateral, top-ups on home loans and using them to buy stocks, punting on stock futures etc. 

“Unquestionably, some people have become very rich through the use of borrowed money. However, that’s also been a way to get very poor. When leverage works, it magnifies your gains. Your spouse thinks you’re clever, and your neighbours get envious.
But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as well learned in third grade – and some relearned in 2008 – any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.” - Warren Buffett, Berkshire Annual Report, 2010
In this context, let me recount the story of Rick Guerin - Buffett's contemporary and acknowledged by him as "Superinvestor of Grahamville". Guerin lost significantly and dropped out of the investment landscape after the steep crash of 1974 when he received margin calls because he was highly levered. He had to liquidate some of his best investments including Berkshire Hathaway stock. Today, everyone knows of Buffett and Munger but hardly anyone has heard of Guerin. (In fact, to be honest I was also not aware of Guerin's history before reading about it in one of Mohnish Pabrai's interviews).

As Buffett said in the quote above some people can become rich but in an alternate history (Taleb's definition) of events can become a pauper. So, keep away from leverage.

6 comments:

  1. What about buffett himself using leverage ? Buffett himself doesnt practise what he preaches. Leverage, betting against the dollar, derivatives. I am a big fan of his. But not of the folksy image he has created for himself.

    You can read a paper called Buffett's Alpha

    http://www.econ.yale.edu/~af227/pdf/Buffett's%20Alpha%20-%20Frazzini,%20Kabiller%20and%20Pedersen.pdf

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    1. You are 100% correct, Anish. But, I think you, I and everyone else including Buffett know that he is in a different league. What applies to him may or may not apply to others. Buffett says that leverage, derivatives, currency speculation, etc, etc are very risky. He is dead right. He knows however how to mitigate the risk and come out trumps. He is more risk averse than almost anyone I have come across and would not put his money (which he worships) to risk otherwise. Shambo !!

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    2. Another consideration is Buffett has a very low part of his investments in hedges (derivatives) and usually it is a defensive hedge. He is not trying to use leverage to enhance returns, which is where greed steps in and causes people to over-leverage and sometimes get killed.

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  2. Could you also provide some examples in the Indian context, it would make greater comparison.

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  3. Interesting take on alternate history. Leverage is just 1 of the factors. Ovarian lottery suggests that a 1000 and 1 thngs cud have gone wrong. He was just destined for glory.

    easy to shout don't use leverage wen ur cost f capital is minus 5%. Its like once u become successful, anything u do becomes the syllabus for idiots who follow u.

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  4. Leverage is such a beneficial part of stock investment, we can increase our investment by multiple times. stock tips

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