I like to spend time going through Warren Buffett (Trades, Portfolio)'s greatest mistakes. I don't do this for any malicious reason. Rather, I'm trying to understand how he made these mistakes because, more often than not, the Oracle of Omaha is painted as one of the greatest investors of all time who has never made any blunders.
That is just not true, though. He has made plenty of mistakes. How Buffett deals with these mistakes is far more important than the error in the first place. Every time he has made an investing mistake, he has quickly acted to stop any further losses and move on as soon as he realized the problem. I think this is by far one of the most important lessons we can learn by studying Buffett.
It's not how much you make that really matters in investing; it's how much you don't lose and what you do when you're looking at a large loss that really matters. It's better to cut your losses and run more often than not. There are always going to be other opportunities. One has to weigh up the opportunity cost of sticking with the losing investment versus taking a new position in something that might grow much faster.
One of Buffett's biggest errors so far was his decision to make a substantial investment in Salomon Brothers in the fall of 1987.
Buffett's big mistake
Buffett allocated $700 million of Berkshire Hathaway's BRK.A BRK.B cash, the most significant single investment the conglomerate had made up to that point, in redeemable convertible preferred stock in the investment bank. As part of this deal, Buffett and his partner, Charlie Munger (Trades, Portfolio), received seats on the board of directors.
At the time, it seemed like a strange deal. Buffett had repeatedly attacked investment bankers in the past for their lavish lifestyle and large fees, which produced high costs for individual investors.
But the terms offered by Salomon were too attractive to pass up, it seemed. The group wanted to buy out a stake held by Minerals and Resources Corp. Ltd., which was part of the giant mining group Anglo American LSE:AAL.
Minerals owned 12% of Salomon, and management was worried this position might fall into the hands of a corporate raider. So, they offered Buffett 9% a year to provide cash.
The Oracle of Omaha later explained that he knew this wouldn't be one of his famous "three baggers," but he was having a hard time finding other suitable investments.
This seems to suggest that Buffett had an itchy trigger finger. He wanted to make the investment and get that 9% annual even though it might not have been the best decision. The investor who once declared that every successful person says "no" to almost everything couldn't bring himself to say "no" on this deal.
Buffett's instincts about investment bankers turned out to be right. Salomon's traders were breaking the law, and the firm came close to bankruptcy when its counterparties started to cut it out. Buffett and Munger had to step in to convince regulators and the group's counterparties that it was trying to move on from these mistakes.
Things got so bad that Munger himself had to come on as the group's general legal counsel.
Munger's former law firm, Munger, Tolles & Olson, also came on board to provide legal advice and help the group fight its legal battles with regulators.
Ultimately, the company's problems were resolved, and it was later acquired. Buffett made a profit on the investment, but it took him nine long months in the chairman position to stabilize the business and countless hours working with Munger's team to rectify the company's problems. If he had not had this experienced team at his disposal, Buffett might have incurred significant losses on his investment.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Why Ben Graham's Mr. Market Is Relevant for the Current Market
- The Current Market, Warren Buffett, Cinderella and Known Unknowns
- Charlie Munger the Entreprenuer
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