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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.

Larry Hilibrand lost $400 million—an enormous sum—arbitraging the difference in interest rates on mortgage-backed bonds. He was convinced that he could make back the loss on the mortgage arbitrage if the firm would double his bet. Buffett agreed with Hilibrand in this instance and gave him the money for the trade—which in fact reversed to become profitable.

The arbs had an almost supernatural belief in their own abilities, and as their corner of the market became crowded, they wanted to expand into even more types of arbitrage that involved more variables and less certainty. They relied heavily on computer models driven by complex mathematics, but always said these were only guideposts. Buffett and Munger felt that using models to make investment decisions was like driving a car on cruise control. The driver might think he was fully alert and attentive, but would find out differently when the road turned winding, rain-slicked, and full of traffic.

What the arbs really wanted, however, even more than capital to invest, was J.M. During Salomon’s recovery, Meriwether waited on the sidelines at first while the arbs begged to bring him back. But while Deryck Maughan made polite noises, everybody knew he did not want Meriwether back. Nevertheless, Buffett and Munger had given a thumbs-up, with some conditions. Meriwether had to have supervision. He could return to his old position but would have to report to Maughan, with less freedom to run his operation. Unwilling to work under a shorter leash, Meriwether had broken off negotiations and in 1994 went off to found his own hedge fund, Long-Term Capital Management. It would operate the same way as the bond arbitrage unit at Salomon, except that Meriwether and his partners got to keep the profits.

One by one, Meriwether’s key lieutenants left Salomon to join him at the new harbor-front offices of Long-Term Capital Management in Greenwich, Connecticut. Deprived of his biggest moneymakers, Deryck Maughan saw the “for sale” sign heading for Buffett’s block of stock and began planning for the day when Buffett would wash his hands of Salomon.13

In his 1996 shareholder letter, Buffett said that “virtually all stocks” were overvalued. Whenever the market ran hot it was because Wall Street was in vogue. That year, Maughan thought it timely to pitch the restaurant in front of Salomon’s casino to Sandy Weill, CEO of Travelers Insurance, as the anchor tenant in a global financial shopping mall that could compete with Merrill Lynch. Weill supposedly still resented Buffett for the sweet deal Berkshire got after Weill’s squeeze-out in the Fireman’s Fund sale more than a decade earlier. He distrusted the arbitrage casino, but he saw an opportunity for the restaurant chain on a global scale. When he bought Salomon for Travelers, some observers felt that since Solly hadn’t done well