Early Buffettology

Way back in March, 1982, Warren Buffett was not an immediately recognisable brand name. But, he was already a significant investor with an equity portfolio of USD600 million. Compared to Berkshire's current asset value of USD300 billion and a market capitalisation of USD150 billion, that 1982 equity portfolio may seem a trifle small.

Such a view would belie the importance of content and substance over form.

In a letter dated 5th March 1982, Buffett had written to a legislator warning against the rise of derivative securities products. Anyone who has read my earlier posts on derivatives will know how sceptical I am about this dubious securities instrument.

So, I was delighted to read that Buffett had held a similar view way back in 1982 when derivatives began to gain some measure of ascendancy. In that maiden wave, derivatives reached its apogee with the likes of Michael Milken and junk bonds.

I was even more delighted to discover that to enlighten the said legislator, Buffett had equated derivatives to gambling products offered in places like Las Vegas.

Here's an extract of Buffett's letter as reported:

In the 1982 letter Buffett argued that the "propensity to gamble is always increased by a large prize versus a small entry fee, no matter how poor the true odds may be. That's why Las Vegas casinos advertise big jackpots and why state lotteries headline big prizes." By small entry fee he was referring to the cost of buying or selling an option or futures contract on the S&P 500 index, a small fraction of the index's market value.

"In securities," Buffett argued "the unintelligent are seduced by low margin requirements through which financial experience attributable to a large investment is achieved by committing a relatively small stake." Harking back to the wild markets of the 1920s when the boom in stocks was accentuated by 10% margins, Buffett warned that "10% down payments" are simply a way around the margin requirements and will be immediately perceived as such by gamblers throughout the country." In ending the four-page letter Buffett warned that "the net effect of high-volume futures markets in stock indices is likely to be overwhelmingly detrimental to the security-buying public and, therefore, in the long run to capital markets generally."

If that is Buffett's damning observation of derivative products, there is hardly any doubt as to his views on gambling as an activity.