Warren Buffett (Trades, Portfolio) has warned investors about the risks of borrowing money to buy stocks again and again. He has also said that he has never borrowed a significant amount of money to invest and never plants to.
Buffett on borrowing
Buffett's comments on borrowing are very sensible. It all comes down to volatility.
In the Oracle of Omaha's 2017 letter to investors of Berkshire Hathaway (NYSE: BRK.A) (NYSE: BRK.B), he presented a table showing the returns of the conglomerate's stock price between 1973 and 2009.
During this period, on four occasions, Berkshire's stock price dropped by between 59% and 37%. According to Buffett:
"This table offers the strongest argument I can muster against ever using borrowed money to own stocks. There is simply no telling how far stocks can fall in a short period...
Even if your borrowings are small and your positions aren't immediately threatened by the plunging market, your mind may well become rattled by scary headlines and breathless commentary. And an unsettled mind will not make good decisions."
In an interview with CNBC after the letter was published, he said, "It is crazy in my view to borrow money on securities. It's insane to risk what you have and need for something you don't really need... You will not be way happier if you double your net worth."
But here's the thing, while both Buffett and his right-hand man, Charlie Munger (Trades, Portfolio), have tried to discourage investors from using leverage, they both have, in the past, borrowed significant amounts of money to turbocharge returns.
Buffett's big loan
Glen Arnold's book, "The Deals of Warren Buffett (Trades, Portfolio), Volume 1: The First $100m," explains how a young Buffett borrowed about 25% of his net worth to increase his capital available for investment in the stock market in 1951.
At the time, Arnold reports that the young investor had around $20,000 of savings, and despite receiving advice from his mentor, Benjamin Graham, as well as his father, not to invest in the stock market because prices were too high, he went ahead and started buying anyway:
"He did not agree with their logic and made up his own mind, deciding that 1951 was a perfect time to pick up good companies. He thought the potential was so great for the first time he borrowed money to buy shares (he borrowed a quarter of his net worth $5,000)."
Unfortunately, Buffett ended up making a few mistakes with his capital. He bought a Sinclair gas station with his friend for $2,000, which ended up being a total loss.
He also bought shares in Cleveland Worsted Mills, a deep value stock. Arnold describes the company in his book:
"As well as Cleveland Worsted Mills selling at half its NCAV, it paid a high proportion of its earnings in dividends. These combined factors made Cleveland appear an attractive investment and Buffett sold the idea of this investment to stockbroker clients in Omaha. Then it went wrong -- the company faced intense competition from textile plants in the Southern US states and from synthetic fibers. It made large losses, cut its dividend and its share price dropped."
As I have explained in a previous article, Buffett was able to make back the money he lost on the Sinclair station and Cleveland Worsted Mills in a relatively short space of time. Nevertheless, this scenario makes it clear how risky it is to borrow money to invest. Buffett took his loss as well and went back into the market to try and find opportunities. If he had let them get the better of him, he might not have become the world-famous billionaire that he is today.
Disclosure: The author owns shares in Berkshire Hathaway.
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This article first appeared on GuruFocus.