Warren Buffett and Charlie Munger had a third partner, Rick Guerin. Like his partners, Guerin was a great investor but he was in a hurry to get rich. Where Buffett and Munger knew that in time they would become wealthy, Guerin leveraged up his investments. When the stock market fell 70% in 1973-74, he got margin calls and was forced to sell his Berkshire stock to Buffett for $40 (currently trading at $494,947.97). And that was the end of Guerin.
Society needs debt. Most people get mortgages to buy their homes. If it wasn’t for debt, you would be saving for most of your working life to buy a home in retirement (never mind all the rent paid in that time). People who want to start/ grow a business need debt to get their idea off the ground. Without being able to borrow, their ideas wouldn’t take off and their entrepreneurial spirit would be extinguished before it had a chance to flourish.
But when we take on debt, we take on an obligation to pay it back. And while we have this debt, we are restricted in what we do. When we borrow to invest, we take on an increased risk that the investment will not work out but the debt will remain afterwards. This has most recently been seen with the “crypto bros” who became crypto millionaires overnight. A lot of these bros financed their investments by credit card debt. The 24% interest rate was cheap compared to the returns they were making. But when the value of crypto crashed, lots of cryptos turned out to be worthless. The credit card debt still had to be repaid.
If you are patient, you can grow your wealth without taking too much risk. Borrowing to invest just gives the illusion that you are actually wealthy. Real wealth is calculated after debt is deducted not before.
Bill and Amy both have €100,000 to invest. Bill is in a hurry to get rich, so he leverages up his money and borrows €500,000. He now has €600,000 to invest on day one. It grows by 6% per annum and is worth €1,437,935 after 15 years. But when we peek behind the curtain we see that Bill has to repay his debt over 15 years at an interest rate of 8%. This costs him €4,778 a month or a total of €860,087 over the term of the loan. So his net gain is
He has to repay his loan over 15 years at 8%. This is going to cost him €4,778 a month. His investment grows by 6% per annum and when the loan is paid off, it is worth He has repaid €860,087 in debt over that term, so his net gain is €477,848.
Amy invests her €100,000 without any borrowing. At the end of the 15 years, she has €239,656, so her gain is about 1/3 of Bill’s. But Bill invested six times more than Amy. And for 15 years, he was obligated to repay €57,336 in debt. If things in the economy got bad, not only might the value of his investment fall, but he may also struggle to repay his debt which may result in his loan be recalled.
With no debt, Amy had no obligations to anyone and can let her investment fall and rise in value without any pressures. But what if instead of having to make loan repayments, Amy invested the €4,778 a month into her portfolio? How would she get on at the end of 15 years when Bill was finished repaying his debts? She would have €1,617,194!!! So, not only would she have less pressure to meet debt obligations, she would end up with more money.
Steven Barrett
24 April 2023