Warren Buffett On LTCM, Blind Spots, Leverage, and Unnecessary Risk

Warren Buffett On LTCM, Blind Spots, Leverage, and Unnecessary Risk

September 8, 2015 Value Investing Research
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(Last Updated On: September 8, 2015)

In 2007, Warren Buffett gave an extended talk to a group of MBA students at the University of Florida.

Warren Buffett with Fisher College of Business Student _ Flickr - Photo Sharing!_2015-09-08_08-27-06

 

Below are some highlights:

Question: You were rumored to be one of the rescue buyers of Long Term Capital. What was the play there? What did you see?

Buffett: …It’s…an interesting story…The whole story is really fascinating because if you take John Merriwether, and Eric Rosenfeld, Larry Hilibrand, Greg Hawkins, Victor Haghani, the two Nobel Prize winners, Merton and 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…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…In aggregate, the 16 had 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 of 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. And that to me is fascinating….

One fascinating thing about the LTCM experience is that it so dramatically defies traditional expectations. The setup was nearly perfect for LTCM. As Buffett notes, these were smart, experienced people investing their own capital. The situation satisfied all the seemingly required conditions for success. Why wouldn’t you want to invest alongside of them? What more could you ask for? But as Buffett points out, appearances can be deceiving. We can focus on and rely on the wrong things. IQ may not protect you. Experience may not protect you. People investing their own money with you may not protect you. If these things can’t protect you, what can protect you? Perhaps avoiding overconfidence is the most important element of investing?

Buffett goes on to highlight the first of three things that can protect you:

…But to make money they didn’t have and didn’t need, they risked what they did have and did need, and that’s foolish. That is just plain foolish. 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 one that you succeed or 1,000 to one that you succeed. If you hand me a gun with a thousand chambers – a million chambers in it – and there’s a bullet in one chamber, and you said, “put it up to your temple, how much do you 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. [Laughter] So I’m not interested in that kind of a game. And yet people do it financially without thinking about it very much.

The first thing that can protect you is an awareness of the potential downside. If bankruptcy or death is the potential downside, then it doesn’t really matter what the upside possibilities are. The upside becomes totally irrelevant. In this view, there are certain bets, regardless of how asymmetric they may appear, that should be beyond consideration by a reasonable and prudent actor.

Buffett goes on to highlight a second thing that can protect you:

There was a great book…the title was, “You Only Have to Get Rich Once.” Now that seems pretty fundamental, doesn’t it? …If you’ve got $100 million at the start of the year, and…you’re going to make 10% if you’re unleveraged, and 20% if you’re leveraged, 99 times out of 100. What difference does it make at the end of the year whether you’ve got $110 million or $120 million? It makes no difference at all…It makes absolutely no difference. It makes no difference to your family. It makes no difference to anything. And yet the downside, particularly in managing other people’s money, is not only losing all your money, but it’s disgrace and humiliation, and facing friends whose money you’ve lost and everything. I just can’t imagine an equation that that makes sense for. And yet 16 guys with very high IQs who are very decent people, entered into that game…I think it’s madness.

The second thing that can protect you is an awareness of what the potential monetary upside actually means to you, in practical terms, since this tempers the desirability of taking risk to enhance returns. It’s an attempt to shift perspective. In Buffett’s example, the addition of leverage adds to returns, in expectation, but what is the true effect these potential returns would have on you and your life circumstances? Buffett’s conclusion? Not much. Or, as a friend of mine once asked, “If you were to add an extra zero to your net worth, what would change?” It’s a question worth asking, and the answer might affect the kinds of risks you are willing take, even if they look like remote risks.

Buffett goes on to discuss blind spots:

It’s produced by an over-reliance…on things…those guys would tell me…a six sigma event wouldn’t touch us…but they were wrong…history does not tell you the probabilities of future financial things happening…The same thing in a different way could happen to any of us…where we really have a blind spot about something that’s crucial because we know a whole lot about something else…It’s like Henry Kaufman said… “the people who are going broke in this situation are of two types: the ones who knew nothing, and the ones that knew everything.

Our tendency to discount the six sigma event is, of course, exactly what Nassim Taleb warned about in his book, “The Black Swan: the Impact of the Highly Improbable.” The smart, experience investors at LTCM simply did not consider such a rare event as what occurred to be plausible. They expressed this view by betting the ranch. This blind spot was their fatal error. And while it was crucial, they simply missed it.

This brings us to the third thing that can protect you. As Buffett points out, one of those crucial factors you should always consider is leverage:

…We never…borrow money…I never borrowed money…I never borrowed money when I had ten thousand bucks…because what difference did it make? I was having fun as I went along and it didn’t make any difference whether I had $10,000 or $1 million or $10 million…I was going to the same things when I had a lot of money as when I had very little money. If you think about the difference between me and you, in terms of how we live…we wear the same clothes…we all go to McDonald’s…and we live in a house that’s warm in winter and cool in summer…and we watch…a big screen…our lives aren’t that different.

It’s comforting to know that I can wear the same clothes, eat the same food, and watch the same TV as a billionaire like Buffett. And so, in the end, why swing for the fences by using leverage? Even if you’re successful, what would change?

The third thing that can protect you? Forgo the use of leverage. Without leverage you may just end up better off anyway.

Victor Haghani, who was a co-founder of LTCM, seems to have learned this lesson. He has launched a new firm, Elm Partners, which emphatically does not use leverage. As Haghani put it in this Bloomberg article:

Sometimes I reflect if I had been investing my earnings in something like Elm rather than Salomon stock and LTCM, I’d have done much, much better.

Bottomline: Think hard about blind spots, leverage, and unnecessary risk. These three elements, in isolation, are not necessarily devastating, but combined with a dose of overconfidence and the results can be a disaster.


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About the Author

David Foulke

Mr. Foulke is currently an owner/manager at Tradingfront, Inc., a white-label robo advisor platform. Previously he was a Managing Member of Alpha Architect, a quantitative asset manager. Prior to joining Alpha Architect, he was a Senior Vice President at Pardee Resources Company, a manager of natural resource assets, including investments in mineral rights, timber and renewables. He has also worked in investment banking and capital markets roles within the financial services industry, including at Houlihan Lokey, GE Capital, and Burnham Financial. He also founded two technology companies: E-lingo.com, an internet-based provider of automated translation services, and Stonelocator.com, an online wholesaler of stone and tile. Mr. Foulke received an M.B.A. from The Wharton School of the University of Pennsylvania, and an A.B. from Dartmouth College.


  • robbo

    Great find David

  • Michael Milburn

    Really good post. I was unaware that Buffett at one point was part of a bailout offer for LTCM. Also didn’t realize the mentioned John Meriweather of LTCM was the same man as when Buffett swooped in to save Salomon from the rogue trader scandal.

  • Ben Lewis

    Great thoughts, especially the part about adding another “0” to your net worth.

  • It is simply a lie for Buffett to say “we never borrow money” when his average leverage is calculated to be 1.6-to-1. His returns and his wealth would be much lower without leverage. Borrowing from internal sources is still borrowing. See “Buffett’s Alpha” by Frazzini et al.

  • great point!

  • jlglex99

    “Avoiding overconfidence.”

    Yes, I agree that is the key to success in the markets. I confess to incurring significant losses myself, based on overconfidence. After all, I was a Summa cum Laude graduate of a top notch boarding school and had then gone on to Harvard. What could I possibly do wrong?

    Had I been “systemically important,” I might’ve been bailed out by the feds, but I wasn’t that big or “important.” So, I had to eat my losses.

    Going forward, it seems to me that it might be useful to ask the following questions. “To what degree has overconfidence become institutionalized into the global capital markets?” “How does one calibrate “overconfidence” in investing?” Without some well anchored, financial metrics, overconfidence can be difficult to detect.

    These days, firms like Morgan Stanley are running with Basel Capital Ratios in the neighborhood of 14%, which is considered to be a very conservative capital ratio in the world of global finance and banking regulation. Indeed, it is significantly higher than the capital ratios that the big, publicly traded financial conglomerates were carrying pre-2008. So, no need to worry about that, right? After all, the greatest economists in the world run the Federal Reserve, and they have signed off on 14% as a reasonable, even safe, capital ratio for the banks.

    I’m not so sure about that, actually. 14% Equity-to-Capital is still a very high degree of leverage. It equates to 86% Debt and 14% Equity, which translates to a debt-to-equity ratio of 6.14. Would an equity analyst in the industrial sector of the S&P500 use the term, “conservative” to describe a balance sheet with a debt-to-equity ratio of 6.14? Probably not.

    A company like General Electric would be taken to the woodshed for having that kind of leverage on its balance sheet. So, why do we all accept 14% as a very conservative and well-regulated Basel Accord capital ratio for an institution like Morgan Stanley?

    Is it because the Federal Reserve has signed off on that figure? Is it because we have utmost respect for international agreements that are signed in Switzerland, like the Basel Accords? Or, is it a herd phenomenon, with the blind leading the blind?

    The founders of this country – the greatest and most prosperous nation in the history of the world – had very little confidence in centralized government institutions, like the Federal Reserve, and even less so in global alliances and their institutions. Perhaps more to the point, 6.14-to-1 is an extremely high debt level by anyone’s standards, and even more so for an institution from which deposits can be rapidly withdrawn on very short notice.

    I’m not predicting a run on the banks in the USA, but I do believe that the highly leveraged stance of the world’s largest banking institutions may be one of the greatest risks faced by modern investors, even now after the financial community has supposedly learned the lessons of 2008.

  • rational

    But that is a different type of leverage, right 🙂 ?

  • leverage that is hard to margin call is great leverage!

  • great commentary and certainly interesting. There are also potential anchoring effects going on here, where moving from 12-14 seems great because the equity to capital ratio is so low. But what if it went from 50 to 14? would we come to the same conclusion that we are “good to go.”
    Lots of psychology potentially at work here…

  • jlglex99

    Psychology? Yes. And, dependency, as well. The economy is highly dependent on debt. Everywhere you look, there are mountains of debt. 50+ years of Keynesianism has left a legacy of debt.

    The childless J.M. Keynes used to dismiss concerns about the long term build up of debt by saying, “Who cares? In the long run, we are all dead!”

    Well, Keynes is now dead, and we are left to sort out the mess that he left.

  • jlglex99

    On related but different note, it seems to me that the current Federal Reserve policy might be counter productive. Currently, the Interest on Excess Reserves (“IOER”) is higher than the very short term money market rates, including the Federal Funds Rate; and there are several Trillion in excess reserves at the Fed right now.

    This strikes me as counter-productive, in terms of economic stimulus. Those excess reserves represent potential loans in the real economy, but they are currently sitting at the Fed, unused in the real economy.

    Wouldn’t it be more stimulative to raise the Federal Funds Rate to a level that is above the IOER, in order to create an incentive for the banks to “put those reserves to work” in the real economy?

    I realize that sounds counter-intuitive, because usually an increase in the Federal Funds Rate is considered to act as a “brake” on the economy. But, there are A LOT of excess reserves at the Fed right now, which could be drawn into the markets by a higher Fed Funds Rate, it seems to me.