AUDIENCE MEMBER 00:00
I heard you mentioned in the past about the one word “Over lever or leverage,” and I know that’s a very dangerous word when it comes in investment. So can you share a little more on that and whether it’s ever a good idea to use leverage to invest?
MOHNISH PABRAI 00:18
Yeah. I would say the short answer is probably a good idea to avoid it.
I do know that, you know, even someone like probably Charlie Munger used leverage in the very early days, probably has no desire to use it at this point or even for the last several decades.
So I think the simple answer is that it’s probably best – I mean there can be situations where leverage may make sense, but I would say the – if one never use leverage that will keep you out a lot of trouble.
So I think generally speaking, you know, the thing about the power of compounding is there are really three elements which control kind of, you know, what your end number ends up being. So one is you know, the amount of money you start with, the second is your rate of return and the third is the length of the runway, right?
So the combination of those three elements get you to the end result and the most controllable one of those three is the length of the runway because the thing is especially for most of you in the room, if you’re in your early 20s, you have a probably a 60 or 70 or 80 year runway.
And the important mental model there would be spend less than you earn and even if you didn’t get spectacular rate of return, if you use the entire runway length, you’re going to get a spectacular end result.
And so for example, you know, I think this is a – I think maybe a year ago, maybe 18 months ago, I was – I picked up my younger daughter she goes to school at NYU and it was late at night about two o’clock in the morning we were driving back from LAX.
And I thought this was a good time to explain the magic of compounding to her and so she had just done an internship the previous summer and she had made $5,000 that summer and the IRA laws allow you to put all of that into an IRA and which I had asked her to do it and we’re done.
And then I told her you know, I said, you know, the thing is that your 20 for example – and actually she did that, I’m sorry that internship was when she was 18 – So I said you’re 18, you got this $5,000 and I said, what is the value of this $5,000 when you are, for example, 60, 65 or 70 years old for example.
And I said, let’s say for example the returns are decent, let’s say you are doing about 15% a year for example, so one of the mental models is rule of 72 which is if you’re doing 15% every five years, the money is going to double.
And so, if you go from 18 to 68, that’s 50 years and if you’re doubling every five years, it’s 2 to power of 10 and my daughter is falling asleep while I’m doing all this math for her. And 2 to power of 10 is 1024 and so throw away the 24, the $5,000 becomes $5 million, tax deferred, at this point she was wide awake.
Okay, so I said, you know that $5,000 at 18, at 68 becomes $5 million, I said but you know at 19, you’ll do another internship maybe make another $5,000-$6,000, and at 20 you do another one and at 21 another one and then at some point you graduate and you might have some savings that might be even maybe more than $5,000. So I said all of this is getting saved and invested, what is the net worth at 68?
And so she said, “it's too large, you know, I can’t do the math, it’s too large.” And the reality is that most humans don’t get there, right? So most humans don’t get to these, you know, huge numbers at those ages. Why don’t they get there, right?
So one is when they leave their job, they take the 401K and they go on vacation, okay so you cannot, you know, one of the 11th commandments; "thou shalt not take the 401k and not roll it over." (Laughter) Okay?
Very important, you can’t screw up the compounding engine, so you have to basically – I mean the thing is the actions required to get to very significant sums without even earning that much money over a lifetime are very simple.
The first action is that you consistently spend less than you earn, and the second action is you – even if you don’t know investing, just put it in index fund and forget about it. And so even if you’re not compounding at 15%, I mean you can take the same number and say let’s say the double comes in 10 years, even that’s fine.
In a 50-year period, you’ll get 5 doubles, 2 to the power of 5 is 32. And again when you start doing that every year with all the numbers, it will get to big number. So that is the key is you don’t need leverage, you need to be aware of the fact there are magical properties to compounding and there are negative magical properties to compounding if you borrow at high interest rates.
So if you have credit card debt, then you – the whole process is working in reverse which is terrible. And so don’t have credit card debt, pay off the credit cards always, spend less than you earn and start very early. It’s – if you lose your 20s and you start compounding in your 30s, that’s a massive loss, that’s a lot of lost opportunity so I think you really want to get started very early.