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Buffett: The Only Way Smart People Can Get Clobbered Is With Leverage

- By Rupert Hargreaves

If there's one thing that is responsible for more business and investor failures than anything else, it is leverage and borrowing. This is something Berkshire Hathaway (NYSE:BRK.A)(BRK.) CEO Warren Buffett (Trades, Portfolio) and his partner, Charlie Munger (Trades, Portfolio), have spoken about many times in the past.

It is not just Buffett who has warned about the perils of borrowing too much. Virtually every successful investor has cautioned that leverage is an extremely dangerous tool for investors and companies to use, and should be avoided at all costs.

Impossible to overstate the risks

I do not think it is possible to overstate the dangers of leverage, both for companies and investors. Business is not a science, but an art, and neither companies nor investors ever know what is around the corner.

A business could be achieving fantastic results one day, and suddenly find itself in a challenging position the next. Companies with strong balance sheets can weather short-term problems, but investors and businesses that have leveraged balance sheets and depend on capital markets or third parties to provide liquidity in terms of stress, run the risk of running out of goodwill right when they need it most.

Buffett cautioned investors about this at the 2004 Berkshire Hathaway annual meeting of shareholders.

"So we believe almost anything can happen in financial markets," he said. "And the only way smart people can get clobbered, really, is through leverage. If you can hold them, you have no real problems."

He was responding to a question from a shareholder who asked him to explain how he prepares for low probability events, such as a one in 1,000 catastrophe event in the insurance market or the world running out of oil.

Buffett on leverage

Buffett also said these events are unavoidable and, at some point, every investor and business will have to deal with a catastrophic, low probability event. One thing can be controlled in preparation for these events, however. As Buffett explained:

"Probably the most dramatic way in which we are -- give evidence of our -- of your worries, is we just don't believe in a lot of leverage. I mean, you could have thought junk bonds were wonderful at 15% because they eventually did go to 6%, you would have made a lot of money.

But if you owed a lot of money against them in between, you know, you wouldn't have been around for the party at the end.

So we believe almost anything can happen in financial markets. And the only way smart people can get clobbered, really, is through leverage. If you can hold them, you have no real problems.

So we have a great aversion to leverage and we would predict that a very high percentage of the smart people operating in Wall Street, at one time or another, are likely to get clobbered through the use of leverage."

He went on to say that avoiding leverage is a very powerful tool that helps investors and companies prevent themselves from becoming overextended. Borrowing money to improve returns might seem like an attractive strategy, but at the end of the day, it is a very quick route to bankruptcy if you run out of money.

Furthermore, the Oracle of Omaha said that by avoiding borrowing money, you can avoid getting caught up in Wall Street's manic-depressive cycles. By staying inside your financial constraints, you can help protect "yourself against that sort of insanity wiping you out." Also, having plenty of liquidity available without having to rely on borrowing you can be "prepared to take advantage" of situations brought about by other investors who have overextended themselves.

Some say the best lessons are the simplest. This is a very simple and easy to implement lesson from the head of Berkshire Hathaway, and it is one that I think demands a considerable amount of attention.

Disclosure: The author owns shares of Berkshire Hathaway.

Read more here:

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  • Warren Buffett: Risk, Volatility and Farmland

This article first appeared on GuruFocus.