Don’t Commit the Same Mistake That Caused This Super Investor to Fail Spectacularly

Recently, I was chatting with my colleagues Chin Hui Leong and Stanley Lim when the topic of using leverage in investing came up. Hui Leong and I excitedly brought up the name Rick Guerin, a really smart investor whose returns got destroyed through his use of leverage. It was also then when Stanley said, “Rick who?”

Now, Stanley’s been a keen student of investing for more than a decade and he’s also one of the most knowledgeable investors I know. So, for him to not have heard of Guerin’s tale was something of a revelation for me. If someone like Stanley didn’t know about Guerin – whose story can serve as incredibly important investing lessons – then more ought to be done to spread the word. Here’s me playing my part.

The investing legend that was not to be

The story of Guerin can actually be traced to investing maestros Warren Buffett and Charlie Munger. Today, both Buffet and Munger are renowned the world over but hardly anyone, not even those in investing circles (Stanley is a great example), has really heard of Guerin.

In 2013, money manager Mohnish Pabrai was interviewed by my colleague Morgan Housel and in the interview, Pabrai shared that Guerin, Buffett, and Munger were actually working very closely together on investing deals when the trio had started out.

According to Buffett, all three of them were also equally smart investors; Buffett even labelled Guerin as a fellow “superinvestor” in the seminal investing article The Superinvestors of Graham and Doddsville. But, there was a fundamental difference between Guerin and the other duo. This is how Pabrai describes it (emphasis mine):

“And [Buffett] said, Charlie and I always knew that you would become incredibly wealthy. And he said, we were not in a hurry to get wealthy; we knew it would happen. He said, Rick was just as smart as us, but he was in a hurry.”

To expedite his progress to wealth, Guerin invested with borrowed money in the 1970s – and that was a mistake. When the horrible 1973-1974 bear market in the U.S. came – the Dow Jones Industrial Average (one of the U.S.’s oldest market indexes) fell by almost half from peak-to-trough in that period – Guerin was faced with heavy margin calls. In order to meet those calls, he had to sell his Berkshire Hathaway shares to Buffett. According to Pabrai:

“Warren actually said, I bought Rick’s Berkshire stock at under [US]$40 apiece, and so Rick was forced to sell shares at … $40 apiece because he was levered.”

The same Berkshire shares Guerin sold in the 1970s are worth more than US$218,000 each now. Because of impatience and a dangerous dance with leverage, Guerin had been forced to leave more than 545,000% worth of potential gains on the table over a four-decade period.

The lessons to be learnt

The obvious investing lesson with Guerin’s experience is that leverage is really a double-edged sword and it can cut real deep if we’re not careful. As Buffett wrote in his 2010 Berkshire Hathaway Annual Shareholder’s letter (emphasis mine):

“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.”

Besides the obvious, there’s also another lesson to be gleaned from Guerin’s tale. And that is, timing the market is an extremely tough thing to do. Guerin was an investor as good as Buffett and Munger, but even he couldn’t tell when a bear market was coming. For me, his experience is a great reminder for investors to keep a long-term focus and not try to out-guess the market’s short-term gyrations.

Trying to time the market has been one of the individual investor’s greatest enemies. In contrast, the act of staying invested for the long haul has historically been one of the investor’s best allies.

In the 12-year block between April 2002 and October 2014, the SPDR STI ETF (SGX: ES3), an exchange-traded fund which tracks the Straits Times Index (SGX: ^STI), has delivered an annualised total return of 8.32%. This has happened despite all the troubles which has plagued the world in the interim: The great financial crisis in 2007-09; the European debt crisis and BP oil spill in 2011; the Middle Eastern uprising in 2012; and, the Cyprus bank bailouts, US government shut-down, and Thailand uprising in 2013. And that’s just an incredibly small sample although I shall be stopping here.

All these crises do carry the potential to cause a market decline – I don’t doubt that. But their actual effects on the markets do vary widely. Because of that, it’s almost impossible to second-guess what actually will happen. An investor who dances in and out of the market while trying to pick out the tops and bottoms will thus not be able to enjoy the powerful effects of compounding and of reinvesting his dividends.

It’s also worth pointing out that historically, the longer an investor has stayed invested with the Straits Times Index, the lower his or her odds of losing money. This is how time in the market can be an investor’s ally.

A Fool’s take

Guerin’s tale serves as a great reminder for all investors that even the smartest of them all can’t foresee market crashes and can be crushed because of the use of leverage. Keep them in mind when you invest.

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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 shares in Berkshire Hathaway.