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