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Charlie Munger's Borrowing Binge

There is a lot that Charlie Munger (Trades, Portfolio) and Warren Buffett (Trades, Portfolio) agree on, but one thing that they both agree on more than anything else is the dangers of borrowing too much money.

The debt trap

It is relatively easy for anyone to slip into a debt trap, either by borrowing too much money on credit cards, student debt or mortgages. This means that unlike most of the advice that Munger and Buffett have issued over the years, which is primarily aimed at investors, their advice on debt applies to almost everyone.

In an interview with CNBC in 2018, Buffett 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."

My partner Charlie says there is only three ways a smart person can go broke: liquor, ladies and leverage," Buffett said. "Now the truth is -- the first two he just added because they started with L -- it's leverage."

The ironic thing here is that Munger has made heavy use of leverage in the past.

Munger's borrowing binge

Before he joined Buffett at Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B), Munger managed his own investment partnership. At that time, he was more than happy to borrow money to buy stocks if he thought the risk was worth the reward.

According to Alice Schroeder's book "The Snowball: Warren Buffett and the Business of Life," when Munger saw an attractive opportunity with British Columbia Power, he put more than 100% of his liquid net wealth into the stock and borrowed money to juice returns:

"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."

What I find interesting is the fact that Munger does not talk about this deal much. Munger made the trade because he thought the deal was unlikely to fall apart, but that does not mean that it should be repeated. In fact, I think this is a rare event when we should not copy Munger's actions.

Buffett has said that borrowing is to some extent like Russian Roulette:

"At rare and unpredictable intervals...credit vanishes and debt becomes financially fatal. A Russian-roulette equation--usually win, occasionally die--may make financial sense for someone who gets a piece of a company's upside but does not share in its downside."

This analogy works well here. Munger's British Columbia Power trade worked well and helped to cement his reputation as one of the best value fund managers of the last century. However, for every investor that has made a success with leverage, there must be several hundred or possibly even several thousand who have seen their portfolios wiped out by excessive borrowing.

The question you have to ask yourself is, is the risk worth the reward? Ninety-nine percent of the time, it is not. It is not worth risking everything for that last one percent, no matter how much conviction you have about a particular investment idea. There are always going to be other investment opportunities with better risk/reward profiles.

Disclosure: The author owns shares in Berkshire Hathaway.

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This article first appeared on GuruFocus.