This excerpt from the book Snowball explains why taking debt to make up losses is tempting but not good.
“The advent of the Bloomberg terminal, symbol of the new computerized trading, mirrored the ongoing struggle over Salomon’s identity, which continued within the firm. Its laggard businesses had never gotten back on their feet. In 1994, Maughan had tried to realign pay at Salomon on the theory that employees should shoulder the same risk as shareholders. When times were good, they would get bonuses, but when times were bad, they would suffer as well. There were people inside the firm who agreed with him.11 But that was not the standard anywhere else on Wall Street, so thirty-five senior people walked out the door. Buffett was disgusted with the employees’ unwillingness to share the risk.
Deprived of Meriwether to bonus-pimp for them, the arbs fought for their share. Buffett was willing to pay them for results—the firm still made most of its money from arbitrage—but increasing competition made it harder for them to produce.
Arbitrageurs make a bet that a temporary gap of prices between similar or related
“assets will eventually tighten. For example, the bet may be whether two nearly identical bonds will trade at a closer price.12 With so much new competition, the easy trades had become scarcer. The arbs took larger positions with more risk. When they were losing, they doubled down and increased the size of their trades. In both cases, they did so because margins on trades were falling, and doing bigger trades, often using debt, helped offset that.
The rules of the racetrack said not to do so, because you don’t have to make it back the way you lost it. The reason is the math of losing money, which works like this: If someone has a dollar and she loses fifty cents, she has to double her money to make back what she’s lost. That’s difficult to do. It is tempting to borrow another fifty cents for the next bet. That way you only have to make fifty percent (plus the interest you owe on the loan) to get back whole—much easier to do. But borrowing the money doubles your risk. If you lose fifty percent again, you’re history. The loss has wiped out all your capital. Hence Buffett’s sayings: Rule number one, don’t lose money. Rule number two, don’t forget rule number one. Rule number three, don’t go into debt.
The arbs’ strategy, however, assumed that their estimate of value was right. Therefore, when the market moved against them, they only had to wait to make the money back. But “risk” defined this way—in terms of volatility—presumes the investor can be patient and wait. Of course, anyone who borrows to invest may not have that luxury of time. Moreover, to actually enlarge a losing trade required extra capital stashed somewhere that could be forked over on a moment’s notice if the need arose. And capital has an opportunity cost.”
Excerpt From: Alice Schroeder. “The Snowball.” iBooks.
Also published on Medium.