Don’t Give In To the Siren Call of Leverage
So much misfortune in life can be sidestepped if you simply make it a rule to never stretch your finances, yet it’s a rule I see violated more than any other both through observation of those around me and through the messages I receive. Someone can afford a $150,000 house but they try to buy a $250,000 house. Another can realistically go to a college that will cause them to graduate with $10,000 in debt but they want to sign up for the program that will put them $40,000 in debt. Then, not only do they have to hustle to try and meet their legally promised payments, they have to pay rent (in the form of interest expense) on the savings they’ve temporarily borrowed from someone else through an intermediary such as a bank.
Life is much easier when you don’t have this pressure. Unfortunately, even smart people give into this temptation to overspend and gear up the leverage so you need to be vigilant against it. Consider the case of the father of value investing himself, Benjamin Graham. Since we talked about him the other day, it seems an appropriate case study.
In 1929, Benjamin was 35 years old. He had started a small investment company, and augmented his income with writing for major publications. Overseeing $2,500,000 in capital from friends, family, and other clients, Graham had used these funds to purchase $2,500,000 worth of hedged positions as well as $4,500,000 in margined long-term stock positions, bringing his total balance sheet to $7,000,0001. To provide some historical context, if we adjust these figures for inflation, Graham was sitting on $34,200,000 in capital belonging to his stockholders, and he had leveraged this up to $95,755,000, part of which was hedged.
This provided him a very high standard of living. In the past, I’ve laid out the compensation structure of the Graham-Newman Corporation, which gave Ben and his partner high base salaries plus significant cuts of the profits. With a household income that surpassed the wildest imaginings of the typical American during this time, he gave into the hedonism of the day and was living extravagantly, leasing one of the most expensive apartments in New York and employing a cadre of servants. It’s hard to fault him too much considering only a couple of decades prior, he had been left destitute when his father died unexpectedly. The boy Graham had entered the workforce as a teenager and supported his widowed mother. The siren call of a gilt-edged life was too much for him to resist.
As stock prices began to accelerate during the latter half of the 1920s, Graham was writing about the overvaluation with increasing concern. He believed that the holdings in the Graham-Newman portfolio were cheap enough based on underlying intrinsic value that they should survive any downturn, failing to foresee the forced liquidations that would cause even cheap companies to trade at less than the cash balances they held in the bank. Combined with the leverage he allowed himself to take on when times were good, and the improbable misfortune of living during the worst economic collapse in 600 years, he faced a near catastrophic decline in the quoted value of his holdings. By 1932, his business had lost 70% of its net worth.
In his memoirs, Ben reflects on this period by saying, “I blamed myself not so much for my failure to protect myself against the disaster I had been predicting, as for having slipped into an extravagant way of life which I hadn’t the temperament or capacity to enjoy. I quickly convinced myself that the true key to material happiness lay in a modest standard of living which could be achieved with little difficulty under almost all economic conditions.” As James Grant wisely puts it in his opening text of the recent reprint of Security Analysis, this was Graham applying the margin-of-safety concept to his own personal finances. Graham had learned The Micawber Principle.
Sometimes Misfortune Can Lead to Great Triumph
Fortunately for all of us, Graham’s folly led to his greatest triumph. It was with this backdrop, and having suffered these declines, Graham set out to find an investment philosophy that would allow someone to prosper, or at least mitigate risk, in all fiscal environments. While he focused on some technical operations that are simply not possible today (net working capital stocks bought on a widely diversified basis are long gone, unlikely to return until the next Great Depression), the general thought process ended up spawning multiple billionaires, countless multi-millionaires, and saving a lot of people from emotional turmoil. He striped the emotion and excitement out of investing and made it all about the cold, hard cash. He greatly improved the discipline of financial analysts and turned it into a legitimate profession.
Having learned from experience, Graham spent the rest of his life living much more modestly relative to his means. Given his investment acumen, he was still absurdly rich compared to the typical American, retiring to the oceanside enclave of La Jolla, California and spending half the year in France, yet he had none of the financial pressures that accompany so many families. (On a side note, Graham’s French escapades are worthy of their own post given the lessons that can be drawn from his moral failures. He had an affair with his son’s French mistress after the son committed suicide, leaving his long-time wife in their older years to be with the other woman after the wife, quite rightly, refused to spend half her year in France with him as he went around sleeping with another woman. Doing case studies of his life, it’s hard to reconcile the kind man so many people think of fondly with the husband who treated his wife so cruelly.)
Personally, my rule has been that even in a Great Depression, you should be able to maintain your standard of living without losing a single moment of sleep. Others apply different rules. Bill Gates was famous for keeping 12 months of cash on hand so he could pay all of his bills for an entire year even if revenue went to nothing overnight. Suze Orman thinks the average family should keep eight months’ worth of cash on hand as an emergency backstop. In his recent shareholder letter, Warren Buffett mentioned that one of his bequests will involve setting aside 10% of the principal for cash equivalents. The specifics will depend on your unique circumstances, but you have to be prepared for when things go south. They have, they will, and that’s just life. Any system or estate that isn’t built to withstand that adversity is poorly designed or improperly managed so get to work if you aren’t in that position today. It’s even more important than funding your investments.
What if you screw up and find yourself in a situation that requires fixing? Forgive yourself, fix the problem, and move on. If a brilliant mind like Ben Graham can fall prey to cheap money and easy sex, accept you are only human and vow to avoid repeating the mistake. Some of history’s biggest fortunes were made by those who were wiped out entirely. It’s not the end of the world, even if it feels like it.
1 Benjamin Graham and Security Analysis: The Historical Backdrop by James Grant, Introduction to the Sixth Edition of Security Analysis, 2009