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Can We Talk About Leverage?


Buffetteer
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There were some great points raised in this thread http://www.cornerofberkshireandfairfax.ca/forum/berkshire-hathaway/annual-letter-out/ but I hope we can discuss this important topic in more detail here. Warren Buffet does, for the most part, advise against leverage but I do always have this quote in the back of my mind from one of his letters, "If your actions are sensible, you are certain to get good results, leverage just moves things along faster."

 

So, I thinks one of the most sensible uses of leverage is to buy an index fund or BRK stock. But Buffett advises against that in this year's letter.

 

Would love to get input from other members, especially those who have had several years experience with leverage. I know there is a tendency for people who have been successful with the use of leverage to share their experience, and I would love to hear them, but I would also love to hear from those who have been hurt by leverage. I think both examples would be very useful for all of us on this board interested in this topic.

 

I personally am not opposed to leverage. I think of it this way: If you would borrow money to buy a house (mortgage) why not borrow to purchase an index fund or BRK stock. Both are just as safe as real estate investment and the returns are greater. But I am fairly inexperienced with leverage and would love to hear from others.

 

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Guest longinvestor

I've never used leverage in investing. What I've learned from Buffett is that you want to make time your friend in investing. With leverage, time is your enemy. That's enuff for me to know to never do that. Lowering my expectation, I can do.

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Yes, let's get all the people who have been successful with leverage to share their stories. Can't see any possible harm at all in that.

 

Buy an index fund on margin? Suuure, that is probably what good old Warren had in mind when he said "sensible".

 

You're sure you're not just looking for reassurance for a strategy you have already chosen?

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Yes, let's get all the people who have been successful with leverage to share their stories. Can't see any possible harm at all in that.

 

Buy an index fund on margin? Suuure, that is probably what good old Warren had in mind when he said "sensible".

 

You're sure you're not just looking for reassurance for a strategy you have already chosen?

 

Whoaaa, take it down a notch little fella, why all the anger? I suggest you re-read my post, very slowly...a couple times, until you truly understand it and not cherry pick and take things out of context. Did you miss the part about asking for feedback from those hurt by leverage? So just take a deep breath and read it again. No need to be so critical just because someone happens to have a different opinion, is there?

 

Now, what do you think Warren had in mind when he said sensible investing?

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Great thread idea. Leverage is a continuum obviously... There is a significant difference to using 7% money at 80%+ LVR and 3% money at 33% LVR. I would certainly consider the latter for long term investing if you have adequate cash cover and a reliable income stream.

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I personally am not opposed to leverage. I think of it this way: If you would borrow money to buy a house (mortgage) why not borrow to purchase an index fund or BRK stock. Both are just as safe as real estate investment and the returns are greater. But I am fairly inexperienced with leverage and would love to hear from others.

 

I don't think Warren doesn't like leverage.  It's just "good" leverage isn't really available to 95% of investors outside of real estate. 

 

So, in your example, if someone was willing to give you an 80% LTV, 30-year fixed rate loan at <4% pre-tax with which to buy the S&P500 index, Warren would probably advise you to that loan and buy that index and sit on it.

 

The issue is that margin loans are callable, have variable interest rates and are typically short term.  To use THAT kind of money to buy an index is nuts because if the index drops by 50% the next day, your broker will call more capital or force you to liquidate.  With a house, you can live in it for decades and the bank can't do anything about it.  You don't have a "duration match" issue.

 

 

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In the 1973-4 time frame Buffett had Berkshire sell bonds ( if memory serves at around 8% interest) so that he would have money to take advantage of all of the bargains in that bear market.  So Buffett has used leverage effectively.  But it was fixed rate leverage, not a variable rate margin loan.  My source for this is the Lowenstein biography.

 

I have quite successfully used leverage the past 6 years, partly with a new mortgage on my previously paid off house (3.5% fixed rate) and partly with margin.  The margin was generally no greater than 2x my annual gross pretax income, and I have other assets I could tap to pay it off if need be.  I think the time to use leverage is when there is a fairly clear point of maximum pessimism in the market, i.e., some clear inefficiency or irrationality you can point to to explain why bargains are present.  Also, most of my margin went to buying BRK stock when it was close to book value, something I thought was a no-brainer.

 

For me though now is the time to dramatically reduce my margin, which I have begun to do.  I have halved it in the last few months and intend to reduce it to 0 fairly soon.  IMO, now is not the time to use leverage.  There just aren't the bargains out there, or the irrationality, to justify it.

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Assuming the underlying asset you're buying is undervalued, leverage can dramatically improve your returns.  But one major caveat for me is I only like leverage that is non-callable with a fixed interest rate and its greater than 4 years.  This is why a 30 year mortgage, ~4% fixed interest rate was so attractive a few years ago when the real estate was undervalued.  I also like warrants which their expiration date is more than 4 years. Because typically within 2-3 years, you will know if your stock thesis is correct.

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Yes, let's get all the people who have been successful with leverage to share their stories. Can't see any possible harm at all in that.

 

Buy an index fund on margin? Suuure, that is probably what good old Warren had in mind when he said "sensible".

 

You're sure you're not just looking for reassurance for a strategy you have already chosen?

 

Whoaaa, take it down a notch little fella, why all the anger? I suggest you re-read my post, very slowly...a couple times, until you truly understand it and not cherry pick and take things out of context. Did you miss the part about asking for feedback from those hurt by leverage? So just take a deep breath and read it again. No need to be so critical just because someone happens to have a different opinion, is there?

 

Now, what do you think Warren had in mind when he said sensible investing?

 

Not angry at all, just trying to get you to question your own assumptions. And frankly I think it's a tad worrying to see a new thread on the benefits of leverage or people that have had success with leverage basically every week. I'm not going to re-read it, I understood it very well thank you.

 

I don't know what kind of feedback you expect to get from people that have used leverage. It's great if you made a good bet and didn't get margin called? It's great if you are lucky?

 

The fact that you think my post was critical because you have a differing opinion (as opposed to anything factual) is not a great sign that this discussion will be very fruitful.

 

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Yes, let's get all the people who have been successful with leverage to share their stories. Can't see any possible harm at all in that.

 

Buy an index fund on margin? Suuure, that is probably what good old Warren had in mind when he said "sensible".

 

You're sure you're not just looking for reassurance for a strategy you have already chosen?

 

Whoaaa, take it down a notch little fella, why all the anger? I suggest you re-read my post, very slowly...a couple times, until you truly understand it and not cherry pick and take things out of context. Did you miss the part about asking for feedback from those hurt by leverage? So just take a deep breath and read it again. No need to be so critical just because someone happens to have a different opinion, is there?

 

Now, what do you think Warren had in mind when he said sensible investing?

 

Not angry at all, just trying to get you to question your own assumptions. And frankly I think it's a tad worrying to see a new thread on the benefits of leverage or people that have had success with leverage basically every week. I'm not going to re-read it, I understood it very well thank you.

 

I don't know what kind of feedback you expect to get from people that have used leverage. It's great if you made a good bet and didn't get margin called? It's great if you are lucky?

 

The fact that you think my post was critical because you have a differing opinion (as opposed to anything factual) is not a great sign that this discussion will be very fruitful.

 

There are ways to disagree with someone or get them to question their assumptions without the sarcastic, condescending tone.  I read the initial post in this thread as an honest inquiry into the pros and cons of leverage.

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I read the initial post in this thread as an honest inquiry into the pros and cons of leverage.

 

Thank you Rainforesthiker. You're absolutely right, that was exactly my intent. I truly wanted people's perspective, good or bad, as I stated in the initial post. And I do appreciate the feedback from members who have provided their opinion (well, most of them  ;) ).

 

It's interesting how two people can read the same post and one completely understands the meaning whereas the other just does not get it. Unfortunately those that don't get it, don't get that they don't get it.

 

I agree with the general consensus of this thread that leverage in itself is not necessarily good nor bad. When, how, how much, at what rate, etc. all affect the use of leverage. 

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I read the initial post in this thread as an honest inquiry into the pros and cons of leverage.

 

Thank you Rainforesthiker. You're absolutely right, that was exactly my intent. I truly wanted people's perspective, good or bad, as I stated in the initial post. And I do appreciate the feedback from members who have provided their opinion (well, most of them  ;) ).

 

It's interesting how two people can read the same post and one completely understands the meaning whereas the other just does not get it. Unfortunately those that don't get it, don't get that they don't get it.

 

I agree with the general consensus of this thread that leverage in itself is not necessarily good nor bad. When, how, how much, at what rate, etc. all affect the use of leverage. 

 

You guys are probably right, because I really don't understand how this kind of discussion is benign. A sincere good luck with the levered index- & BRK-bets guys.

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I would not be holding my breath for there to be too many people who speak up and say that leverage ended up making them destitute.

 

I suspect that there are four buckets here:

 

(1) Leverage created good results

(2) People in (1) who are willing to share their story

(3) Leverage created bad results

(4) People in (3) who are willing to share their story

 

I suspect that the overlap between (1) and (2) is higher than the overlap between (3) and (4), and that fact is going to be responsible for screwing with people's availability bias and/or sampling.

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I would not be holding my breath for there to be too many people who speak up and say that leverage ended up making them destitute.

 

I suspect that there are four buckets here:

 

(1) Leverage created good results

(2) People in (1) who are willing to share their story

(3) Leverage created bad results

(4) People in (2) who are willing to share their story

 

I suspect that the overlap between (1) and (2) is higher than the overlap between (3) and (4), and that fact is going to be responsible for screwing with people's availability bias and/or sampling.

 

Merket, this is very confusing. I think you mean:

 

(4) People in (3) who are you willing to share their story.

 

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I would not be holding my breath for there to be too many people who speak up and say that leverage ended up making them destitute.

 

I suspect that there are four buckets here:

 

(1) Leverage created good results

(2) People in (1) who are willing to share their story

(3) Leverage created bad results

(4) People in (2) who are willing to share their story

 

I suspect that the overlap between (1) and (2) is higher than the overlap between (3) and (4), and that fact is going to be responsible for screwing with people's availability bias and/or sampling.

 

Merket, this is very confusing. I think you mean:

 

(4) People in (3) who are you willing to share their story.

 

Yes, that's what I meant. I'll fix it in the original post.

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There are different ways to use leverage.

 

1) Buy companies with debt, that way is most similar to a mortgage.

2) Buy call options/warrants

3) Use margin with puts to create synthetic call options, the Eric way. This is similar to a barbell strategy, Nassim Taleb describes this very well in Antifragility.

4) Use margin without protection, probably the dumbest method.

 

I use method 1 and 2, but limit 2) to 5% of the portfolio.

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Invert, always invert: Turn a situation or problem upside down. Look at it backward. What happens if all our plans go wrong? Where don’t we want to go, and how do you get there? Instead of looking for success, make a list of how to fail instead – through sloth, envy, resentment, self-pity, entitlement, all the mental habits of self-defeat. Avoid these qualities and you will succeed. Tell me where I’m going to die, that is, so I don’t go there.  - Charlie Munger

 

Leverage is one of those things that can kill a business/portfolio.

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Invert, always invert: Turn a situation or problem upside down. Look at it backward. What happens if all our plans go wrong? Where don’t we want to go, and how do you get there? Instead of looking for success, make a list of how to fail instead – through sloth, envy, resentment, self-pity, entitlement, all the mental habits of self-defeat. Avoid these qualities and you will succeed. Tell me where I’m going to die, that is, so I don’t go there.  - Charlie Munger

 

Leverage is one of those things that can kill a business/portfolio.

 

True.  But so can other things.  Leverage is just a risk among risks.  Most should avoid it, but then again most should avoid direct stock selection and go through indexes.

 

Thought experiment:

 

Which of the following is riskier:

 

1.)  A ten stock portfolio, equal sized, made up of whatever the current ten most recently discussed names on the "Investment Ideas" section.

 

or

 

2.)  An investment in the S&P 500 index where one buys $115 for every $100, borrowing the $15 on margin. (Margin for decent sized accounts today costs less than 1%.)

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