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Warren Buffett Got Rich Using Borrowed Money to Invest, So Why Does He Think You Shouldn't?

Jordan Wathen, The Motley Fool

Warren Buffett doesn't think it's smart to use debt to buy stocks. He explained in his letter to shareholders this year that Berkshire Hathaway (NYSE: BRK-A)(NYSE: BRK-B) shares have plunged by more than 37% on four occasions, movements that he said "offers the strongest argument I can muster against ever using borrowed money to own stocks."

Of course, some investors criticized this statement because Buffett's record was built on borrowed money. A well-publicized 2013 study said that "Buffett's returns appear to be neither luck nor magic, but, rather reward for the use of leverage combined with a focus on cheap, safe, quality stocks."

The conclusion sure takes the magic out of Berkshire, doesn't it?

America, the levered

In truth, a lot of investors -- yes, even the nitpickers -- are probably using leverage to boost their returns. If you have a mortgage or car loan and simultaneously invest in a 401(k) plan or IRA, you are effectively using borrowed money to invest. It may not feel that way, but investing instead of paying down debt is the same thing as borrowing money to invest.

People who buy homes as their primary residence can use nearly 29-to-1 leverage with FHA mortgages, well above the 1-to-1 leverage most people can get in the stock market. No one bats an eye, but it's a very leveraged bet on seeing home prices (or rents) go up over time.

There's nothing wrong with having a mortgage and investing in a 401(k), or making a small down payment on a home you plan to live in for a long time. It generally works out just fine because the loans aren't callable. It's the terms of the debt, not the debt itself, that Buffett is most worried about.

Warren Buffett at a Berkshire Hathaway annual meeting.

Image source: The Motley Fool.

Good debt, bad debt

Some people like to call certain types of debt "good debt" and other types "bad debt." High-interest debt is always bad debt. Low-interest debt can be good debt, but generally only if the rate is fixed, and the bank can't phone you up and demand that you repay it immediately.

This is why Buffett warns common people like you and me not to use borrowed money to invest -- there isn't much "good debt" available to buy stocks. Individual investors have to use margin loans, which carry variable rates of interest, and include terms that allow the lender to force you to repay them at a moment's notice.

If you use a margin loan to buy stocks, and those stocks go down in value, your broker can phone you up to say "put more money in your account by tomorrow or we'll start selling your stocks." But they don't even have to do that. The Securities and Exchange Commission explains on its website just how dangerous margin debt can be:

Always remember that your broker may not be required to make a margin call or otherwise tell you that your account has fallen below the firm's maintenance requirement. Your broker may be able to sell your securities at any time without consulting you first. Under most margin agreements, even if your firm offers to give you time to increase the equity in your account, it can sell your securities without waiting for you to meet the margin call.

The seduction of leverage

In an interview with CNBC, Buffett said that "my partner Charlie says there [are] only three ways a smart person can go broke: liquor, ladies, and leverage," adding that "the truth is -- the first two he just added because they started with L -- it's leverage."

By 1973, Buffett's earliest investors would have already known he was an incredible investor, and that Berkshire Hathaway owned a portfolio of quality companies, public and private. But had they used margin loans to amplify their returns, they may have well gone broke, given Berkshire shares dropped by 59% from 1973 to 1975, which would easily wipe out the most levered investors.

From 1965 to 1973, Buffett turned $1 of market value into more than $6. Imagine being so greedy that you chose to leverage it up, ultimately losing it all in the ensuing downturn, missing out on seeing your wealth multiply several thousand times more from 1974 to 2017.

Buffett's issue isn't necessarily with leverage, but how you get it. If you can borrow on the same terms as Berkshire, you'd be quite wise to use leverage. But you can't. I can't. Very few people or companies can, which is why Buffett advises investors to stay away from leverage, even if he uses it himself.

It's not hypocritical, it's just simplification. For the 99.999% of people who can't borrow like Buffett, it's very good advice. 

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Jordan Wathen has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.