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The Danger of Trading on Margins

Trading on margin, or borrowed money, seems to be a topic close to the hearts of market participants in Singapore. But just as it can amplify gains, it can also become a knife that cuts both ways.

While investors might be familiar with the exploits of American conglomerate Berkshire Hathaway’s chairman and vice-chairman, Warren Buffett and Charlie Munger, not many might realise that the dynamic duo used to be a trio.

Meet Rick Guerin, an investor whom Charlie Munger once praised as being just as smart as Buffett and himself (some high praise there, considering the phenomenal investing prowess of both Buffett and Munger).

A year ago, money manager Mohnish Pabrai was interviewed by my American colleague Morgan Housel and Pabrai shared how Guerin, Buffett, and Munger used to work closely together on investing deals.

But, Guerin disappeared after making a fatal investing mistake; he was in a hurry to get rich. While Buffett and Munger are both known to be rather averse to investing with borrowed money, Guerin wasn’t.

So, when the American stock market was faced with a brutal bear market in 1973-1974 that saw the Dow Jones Industrial Average (an American stock market index) fall by almost half from peak-to-trough, the levered Guerin was faced with margin calls.

The need to pay up for those calls forced Guerin’s hand and he eventually had to sell to Buffett his Berkshire stock for US$40 apiece, the very same Berkshire stock that’s now going for US$172,350 a share.

Think about this for a second. Guerin was an investor, who on the account of Charlie Munger, was on par with Buffett in terms of his investing skill and acumen. But yet, he was literally forced to let go of more than 430,000% worth of gains in Berkshire’s shares because of a mistake made with leverage.

This brings to mind something Buffett wrote for his 2010 Berkshire annual shareholder’s letter:

Unquestionably, some people have become very rich through the use of borrowed money. However, that’s also been a way to get very poor. When leverage works, it magnifies your gains. Your spouse thinks you’re clever, and your neighbours get envious.

But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as well learned in third grade – and some relearned in 2008 – any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.”

With Guerin, he was one of those “very smart people” who ended up with “zeroes” because of leverage and the obvious lesson here is to not tempt fate and play with fire.

The less obvious lesson though, is also how tough it is to time the market. Think about it, if it were easy to pick out tops and bottoms in the stock market, would Guerin, being levered as he was, not want to sell out before the bear market came? Turns out, he was caught with his pants down when that fierce bear came mauling through him.

Timing the market, like making huge and quick gains through margin trading, sounds like an alluring concept. But the thing is, the odds are stacked against a market timer (as it is with someone using margin).

Investing tenaciously for the long haul might not sound like an exciting concept, but if we look back at history, it’s also one of the best ways that an investor can stack the odds of success mightily in his favour.

The most instructive example would be the history of Singapore’s market barometer, the Straits Times Index (SGX: ^STI). It was at 834 points 26 years ago at the start of 1988. Since then, there have been tremendous ups and downs, but ultimately, the index is now some 376% higher at 3,134 points today.

That’s an annualised return of 5.2% a year, which might not seem much. But if dividends are tacked on, we could be looking at annualised returns of 7% to 8% a year. At a return of 8% per year, an investor could be looking at doubling his portfolio every nine years.

More importantly, over the past 26 years, the longer someone stays invested in the index, the lower his or odds of losing money. That’s what time in the market can do for an investor.

Foolish Bottom Line

The next time you’ll like to gamble by attempting to pick out stock market tops-and-bottoms with borrowed money, look back at history for your odds of success. Don’t follow in the foot-steps of Rick Guerin, a brilliant investor who likely didn’t attempt to time the market, but who fell prey to the dangers of leverage.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing owns B-Class shares of Berkshire Hathaway.