In a 1991 speech at Notre Dame, Warren Buffett (Trades, Portfolio) declared, “If you’re smart, you’re going to make a lot of money without borrowing. I’ve never borrowed a significant amount of money in my life.”
This statement has elements of truth, but it does not give the whole picture. Buffett has used leverage – and so has Charlie Munger (Trades, Portfolio) – to improve returns. They’re not the only ones. George Soros (Trades, Portfolio), Ray Dalio (Trades, Portfolio) and Carl Icahn (Trades, Portfolio) have all built fortunes by using leverage appropriately and conservatively to their advantage.
Buffett: using leverage
When Buffett was first starting out, he did borrow money to invest. At the age of 21, Buffett apparently borrowed 25% of his net worth to invest in stocks, a sizable sum and something many would consider completely reckless. As Alice Schroeder's "The Snowball" describes:
“I was already running short of money to invest. If I was enthused about a stock I would have to sell something else to buy it. I had an aversion to borrowing money, but I got a loan for $5,000 or so from the Omaha National Bank. I was under 21, and my dad had to co-sign the loan.”
Over the past few decades, Berkshire (BRK.A, Financial)(BRK.B, Financial) has gone on to use debt on several occasions, making use of periods of depressed interest rates to build cash reserves and take advantage of market opportunity. To acquire Precision Castparts (PCP, Financial) the company took out a $10 billion bank loan, later repaid with bonds of various durations yielding around 3%.
In his early days, Munger also used debt to boost his returns as the following extract from "The Snowball" describes:
“He wanted to get really rich really fast. He and Roy Tolles made bets on whose portfolio would be up more than 100% in a year. And he was willing to borrow money to make money whereas Buffett had never borrowed a significant sum in his life.
“Munger did enormous trades [with borrowed money] like British Columbia Power, which was selling at around $19 and being taken over by the Canadian government at a little more than $22. Munger put not just his whole partnership but all the money he had and all that he could borrow into an arbitrage on this single stock – but only because there was almost no chance that this deal would fall apart.”
It’s notable that the only example of Munger using leverage is this arbitrage situation, which virtually guaranteed return.
Making low returns high returns
The common theme with Munger and Buffett’s use of leverage is the exclusive use of debt only when the situation has a low risk of loss. Early in his career Buffett only invested in situations he believed had a 0% risk of permanent capital impairment. Therefore, the risk attached to the debt was low. Munger borrowed to make a quick buck.
Dalio, the billionaire founder of the world’s largest hedge fund, Bridgewater, also advocates the use of debt to improve returns. Once again he recommends only using debt to improve the returns from low-risk assets, such as bonds.
In a "Daily Observations" note, sent to clients of Bridgewater titled, "The Biggest Mistake in Investing," Dalio wrote, "The vast majority of investors (that probably means you) are making a huge mistake in their asset allocation. Investors do not have balanced portfolios."
He went on to explain what a "balanced portfolio" is:
"If you accept that in risk-adjusted terms asset classes have roughly equivalent returns, you essentially want to balance them in your portfolio in risk-adjusted terms after taking into account the correlations between them. To get to this point and allow yourself to create the optimal portfolio, you need to utilize leverage to lever up the lower risk assets. Many people still confuse leverage with risk, but the reality is that levering up low-risk assets so you can diversify away from risky investments is risk reducing."
Borrowing: It could be advantageous
The above are three examples of well-known investors who have used borrowed money at certain points to improve returns. On all three occasions, the borrowing of funds has been beneficial but not without skill. Leverage can help improve returns, although you shouldn't rely on it.
A final word. There is one caveat to the above conclusion. All of the investors featured above are some of the best in the world. They’ve done well thanks to their investment skill, not leverage alone. More importantly, these are only a handful of investors; there are most likely tens of millions of other people out there who’ve had their lives, fortunes and families destroyed by debt.
So, yes, debt can be used to improve returns, but I cannot stress how important it is to only use leverage sensibly, following plenty of research. If you can’t, or don’t feel comfortable, don’t do it.
Disclosure: The author owns no stock mentioned.