Slow & Fast
Lose Out or Win It All !!!
“Rule number 1: Never lose money. Rule number 2: Never forget rule number.1” - Warren Buffet
Isn’t it amazing, that time and again you see a really smart, talented, gifted person blow himself up due to his overconfidence in taking bets, where he could go big if was right or lose everything and go home?
That’s exactly what happened last week with Archegos Capital Management and its founder, Mr. Bill Hwang. He built leveraged positions to the tune of USD 100 billion by only putting up 15 cents to the dollar for these massive positions. His preferred instrument was Total Return Swaps and these bets allowed him to amass billions of dollars in less than 7 years but it also is the instrument that led to his downfall and losing it all in less than 7 weeks.
If you like to understand Total return Swaps and how Archegos Capital built and lost its fortune, then you can click here, here, and here.
What I’d like to point out is a simple message - Accumulating Wealth slowly isn’t sexy but it avoids ruin almost always. Accumulating Wealth fast is like a two-edged sword. If it cuts you, it might even kill you.
Accumulating Wealth slowly would require a few (if not all) of the following action steps -
Be patient for Capital to Compound
Stick to your Circle of Competence
Only deal with people you can trust
Keep things simple
Live Frugally
Spend less than you earn
Always factor in the cost of going wrong and if you can afford the consequences
Accumulating Wealth fast requires just one (if not all) of the following action steps -
Follow the herd
Chase the new fad
FOMO induced decisions
Ask for tips
Spending more to look good
Spending more than you earn
Not factoring in the consequences of your decision going wrong
“Leverage is the devil here. Leverage—taking on debt to make your money go further—pushes routine risks into something capable of producing ruin. The danger is that rational optimism most of the time masks the odds of ruin some of the time. The result is we systematically underestimate risk.” - Morgan Housel
Morgan Housel packs truckloads of wisdom in his book ‘Psychology of Money’ and the Archegos Blow-Up story reminds me of the lessons laid out in this book.
Not only was the founder chasing astronomical returns via the use of leverage. Even the bankers were chasing huge fees that Bill Hwang could bring in. He was barred from trading in 2012 by SEC and already had gained a bad reputation due to his insider trades. In spite of the tarnished image, the banks still caved into extending Bill Hwang huge positions via their respective derivates desk.
If you read about the whole episode, it comes down to banks chasing fees and paying no attention to -
Chequered past of the founder
Ramifications of the bet going wrong
Caving into the temptation of onboarding Archegos because other banks were ok with the client
Social proof bias & FOMO bias playing out in the banker’s mind
Incentive bias that made the bankers push their compliance team to give a go-ahead
And Bill Hwang was chasing returns and paying no attention to -
Worst-case scenario
Consequences of Ruin
To set the context, this quote was a part of Buffett’s shareholder letter from more than two decades back, written in 2000. And along with this quote, he used the fairytale of Cinderella to make his point eloquently. This is what he wrote -
“The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities - that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future - will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.”
Whether Capital is available cheaply or dearly, you still got to factor in the cost of ruin. Having a framework that makes you think about worse-case scenarios is very helpful and could act as a blockade for your excitement-laced decision-making tendencies.
Let’s look at owning a house that costs AED 2 million in Dubai. The down payment required is AED 400,000 and the EMI for the next 25 years is AED 7,587 per month @ 3% Mortgage Rates.
Sounds like a good deal. Pay only AED 7,587 per month for 25 years and you could own a lovely 3 BHK apartment in JLT, overlooking SZR and the JBR view. The details of the loan break-up are sourced from Yallacompare and provided below.
All is good here but you must make a decision only after factoring in the worst-case scenario i.e.
In case you lose your job, do you have enough cash balance to pay off the loan if need be
In case you die, does your insurance cover the loan amount (this is mandatory in UAE)
In case you decide to start a business, will you be able to afford a fixed cost of AED 7,587 on your head?
In case you decide to move, will other countries pay the same salary that Dubai does?
In case you are in an emergency, will your property be looked upon for providing the buffer? Is it liquid enough to be disposed of easily?
These are just questions that make you think of homeownership from many angles. I have seen many people owning houses and regretting the same due to huge EMI which restricted career choices for them. Some incurred huge losses when they lost their jobs and had to sell their house as they couldn’t pay EMIs anymore. Some have suffered massively because they couldn’t sell their house and shore up their cash balances when they needed it the most.
On the other hand, does it make sense to stay in a rented apartment and manage the balance funds in a way that could compound your capital in time? Let’s look at this in detail -
Let’s assume your annual rent is AED 60,000 i.e. AED 5000 per month. This saves AED 2,587 per month to be invested. And you saved on AED 555,550 that would have been required as upfront payment if you bought the house i.e. AED 400,000 for the down payment and AED 155,550 for the extras
Sensex has compounded at 11% + for last 25 years and S&P 500 has compounded at 7.5% + for last 25 years. If we assumed that you will get an average return of these 2 markets in the next 25 years (9.25%), then your AED 555,550 could turn into AED 5,072,934 in 2046. Add to this your additional savings of AED 2,587 being invested, which could turn into AED 776,844 in 2046. This amounts to a total of AED 5,849,778.
That is a whopping sum of USD 1,593,944. Now that is a handsome amount of money to plan your retirement with.
Add to this the following benefits -
Optionality to move to any country if need be
Optionality to take a low paying job, in case you cared for that particular role instead of the high pay in the current one
Optionality to start a business of your own
No liability on you and the choices it opens up
Enough cash surplus being invested in markets and left to compound
But the adverse repercussions of this choice is -
Comments from many that you don’t own a house of your own
You can never call your home ‘home’
I also understand the argument someone may have about inflation in property prices and the possibility of current property prices growing significantly in the next 25 years. In my own opinion, this may not happen due to deflationary forces acting on the environment. Zoom, MS Teams, WFH, and many other solutions will make mobility possible and connectivity virtual. None of these are good for property prices in the long term unless of course, the government has an incentive to keep inflationary forces take the asset prices higher and create an illusion of wealth.
Even if I kept the macroeconomics of this situation out of contention, the optionality that staying on rent gives you is very powerful a choice. And it cuts out the possibility of ruin on your home in case of job loss or emergency situation.
Nassim Taleb says, “You can be risk-loving and yet completely averse to ruin.”
In the above example, you are acting risk-averse by staying on rent. At the same time, you are embracing risk by investing in markets and making a conscious effort to compound your capital in years to come.
I was recently reading a book by Vishal Mittal where he interviews legendary investors in India and Anil Goel was one of them. He will be worth INR 500+ crore and he stated that his allocation to the property is less than 1%. Warren Buffet has been in the same house since he bought it in 1958. In no way am I suggesting that property isn’t an asset class to look at.
All I am saying is that leverage on the property isn’t a wise choice in many cases. But it is a smart decision when you can come up with the cash to close the loan amount if need be. Once again, it’s a two-edged sword just like most things are.
A little sugar and the dessert tastes delicious. Too much sugar and it hurts you.
Once a week consumption of red wine makes for memorable evenings. Too much wine on daily basis and that’s going to punch your immunity out.
A little speculation in all the fads taking place today is an enjoyable and an exciting learning experience. But a massive exposure or betting the whole house on fads in the marketplace for chasing extraordinary returns, that could burn your house down.
Bill Hwang may still bounce back and start a new Investment vehicle in an offshore destination. He is a billionaire and may escape the carnage brought on his own firm due to leverage and the risky bets. As for many others, luck and fortune may not be on their side if their bets go horribly wrong.
As Benjamin Franklin said, “It is the eyes of others and not our own eyes that ruin us. If all the world were blind except myself I should not care for fine clothes or furniture.”
Beware of the Santa Claus’s and Easter Bunnies around you. You don’t want to be the fool who was parted from his money.
Wishing you loads of love and luck.
Manish