The short answer to the question I posted in the title of this article is this: Leverage. As for the longer answer, read on. Not even the smartest men in the room can do it Billionaire investor Warren Buffett once shared some wise words on the perils of leverage in the financial markets (emphasis added): “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…
The short answer to the question I posted in the title of this article is this: Leverage. As for the longer answer, read on.
Not even the smartest men in the room can do it
Billionaire investor Warren Buffett once shared some wise words on the perils of leverage in the financial markets (emphasis added):
“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 we all 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.”
Buffett should know – he once saw a close business associate of his, Rick Guerin, succumb to the fate he described above.
Guerin, whom Buffett thought was as smart an investor as himself, was trading on margin in the 1970s in the U.S. stock market. When the U.S. bear market of 1973-74 mauled through, Guerin was caught off-guard and was peppered with margin calls.
Faced with little options, Guerin sold his Berkshire Hathaway stock to Buffett for under US$40 each. These same Berkshire shares are now worth more than US$220,000 apiece.
History repeats itself
A few days back, hedge fund manager Marko Dimitrijevic had to re-learn Guerin’s lesson the hard-way.
According to a Bloomberg article titled “Swiss Franc Wiped Out Everest’s Main Fund,” Dimitrijevic had to close down his largest hedge fund “after losing virtually all its money” last week as a result of a misplaced bet on the direction of the Swiss franc.
As of December, the fund in question – Everest Capital’s Global Fund – had around US$830 million in assets, according to the same Bloomberg article. So, that’s likely more than $800 million gone – in a week.
The Swiss National Bank, Switzlerland’s central bank, had previously introduced a cap on the franc’s value against the euro back in 2011. But, in an abrupt – and widely unanticipated move – the SNB removed the cap last week, causing the franc to soar by as much as 40% against the euro virtually overnight.
Dimitrijevic had been betting on a fall in the franc, so with the currency moving in the opposite direction, the hedge fund manager would obviously be sitting on losses. But crucially, those losses were magnified because of the way currency bets are typically made with leverage – obscene amounts of leverage.
No hard details about Dimitrijevic’s actual bets are known yet (as far as I know). But the following explanation, given in another Bloomberg article, on how financial institutions typically speculate on the franc’s movements, can be instructive:
“Shorting the franc was a popular trade and most firms would leverage their positions some 20 times or more, said [Mark T. Williams from Boston University], who consults for hedge funds. With such leverage a 5 percent move against the position wipes out all the value, yet the trades were seen as relatively low-risk by models used by financial institutions because volatility of the franc was reduced by the SNB’s cap, he said.”
The use of leverage is a very common thing for currency speculators. But when the tide turns against you, that very thing which magnifies your gains can easily destroy you.
A Fool’s take
The realm of speculating in currencies and that of investing in businesses via the stock market (the latter is what we do at The Motley Fool) are two very different things. But, there are still lessons that stock market investors can take away from currency speculators.
Take leverage. As we saw with Dimitrijevic, the likely-use of huge leverage had caused his hedge fund to blow up even when he was making what was deemed a low-risk move by many. This can be directly ported over to stock market investing: An investment into a highly-probable outcome can still be made extremely risky through the use of sky-high leverage.
Leverage is a double-edged sword. Use it wisely – and at your own peril.
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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.