Hearing Professor Linneman (considered one of the top experts in the world on Real Estate) give a guest lecture for my Real Estate Finance class was an amazing experience. Professor Linneman derided the massive use of leverage among many real estate developers and pointed out, “ask any Wharton kid how to increase returns and they’ll all tell you the same thing — increase leverage and borrow more!” [loosely quoted]. Beyond being incredibly entertaining and very blunt, Professor Linneman really drove home the problems that you may face when you expose yourself through even conventionally “reasonable” lerverage when facing awful credit conditions.
Yesterday I read through Warren Buffet’s annual letter to shareholders which he just wrote for Year 2008. You can read it here. To sum it up, his investment firm Berkshire Hathaway had its worst year ever. Their profits plunged 96%. Interestingly enough, Buffet took many positions in derivative instruments.
Now let’s rewind and look at some of the things Mr. Buffet told his investors in his 2003 letter to shareholders.
Derivatives are financial weapons of mass destruction
Derivatives generate reported earnings that are often wildly overstated and based on estimates whose inaccuracy may not be exposed for many years
Large amounts of risk have become concentrated in the hands of relatively few derivatives dealers … which can trigger serious systemic problems
But I can point out that in 2008, he took on large exposures to derivatives and that he is now in a position where he may get burned big time. He was right in 2003, yet he didn’t stick to his own philosophy and took on leveraged bets through derivatives. Credit to Buffet of course is his absolute willingness to take any and all blame ”It is my belief that the CEO of any large financial organization must be the Chief Risk Officer as well. If we lose money on our derivatives, it will be my fault.” That being said, his bets may very well payoff, but it surprised me to see him take such positions.
As an entrepreneur, I would in my own mind hold myself and many entrepreneurs that I know as very risk averse. Some would differ with my personal definition, but I would argue that I have no problem taking risk if I understand it and can control it. Otherwise I don’t play the game. You give me 51% odds on an even bet and I’ll bet with you all day long. The problem becomes when you leverage yourself and put yourself in a position where volatility negates any long term +EV positions you may hold. Volatility and market swings are not risks that you can control. Thus, debt/leverage instruments put you in a position to get knocked out.
I heard a lesson from an extremely well off entrepreneur one time who spoke of how some of his friends had net worths that were multiples of his; he said, “I am not the wealthiest in the world, but I never lost a day of sleep wondering if I would get wiped out. I have some friends who got extremely rich on leverage and some who got completely taken out. I’m fine being in the middle.” And the more and more I learn about business/life, the more I see that you MUST minimize the power of external forces over your success. Leverage may juice up your returns, but it leaves you very vulnerable to external forces.