The Rational Investor #045: Buffett on Risk
Happy Saturday to you,
Welcome to the 45th edition of The Rational Investor Newsletter.
A few weeks back, I shared a quote from Howard Marks on why volatility is not risk. If you missed it, you can read it here. I bring that post up because this week, I read the book, University of Berkshire Hathaway: 30+ Years of Lessons Learned from Warren Buffett and Charlie Munger at the Annual Shareholders Meeting, and came across this same idea that I think is too valuable not to (re)share. The difference is that Marks looked at this idea through a more technical lens while Buffett shared his thoughts via a very simple real-world example.
Onto the main event…
Here’s Warren Buffett on Why Volatility is Not Risk:
“In modern portfolio theory, beta is a measure of volatility, which, in turn, is seen as a measure of risk. The higher the beta, the higher the risk. At least that’s how the theory goes.
Buffett begs to differ, asserting volatility does not measure risk. Beta is nice and mathematical, but it’s wrong.
For example, a couple decades ago, farmland in Nebraska went from $2,000 to $600 per acre. The theory would state the ‘beta’ of farms went way up, so you would be taking far more risk buying it at $600 (as Buffett did) than $2,000/acre.
That, of course, is nonsense. But stocks do trade, and math types like the ability of computers to monitor all those jiggles in prices.
Buffett concluded, ‘This concept of volatility is useful for people whose career is teaching, but it’s useless to us.’
Buffett believes that real risk comes from the nature of certain kinds of businesses, by the simple economics of the business and from not knowing what you’re doing. If you understand the economics and you know the people, then you’re not taking much risk.
…
Munger puts in his two cents, ‘At least 50% of what is taught is twaddle, but these people have very high IQs. We recognized early on that very smart people do very dumb things, and we wanted to know why and who so we could avoid them.’”
The Nebraska farm example is an incredible one because it shows how obviously stupid this concept of “beta (volatility) as a measure of risk” truly is.
It intuitive that an asset selling for a lower price must, by default, be less risky than when the same asset is priced higher—if for no other reason, because you are placing less money at risk at the point of purchase.
But this “volatility as risk” concept is even more ridiculous when considering the ownership of a diversified portfolio of equities.
Because, in this case, we know that the risk of total and permanent loss is—both historically and logically—zero!
This being the case, not only must risk decrease as market prices fall, but prospective future returns must also, inevitably and substantially, increase.
With a market-like portfolio, it looks something like this:
Lower Prices -> Less Risk -> Higher Prospective Future Returns
Important caveat: This is not the case for individual stocks (amongst other assets), but this is inarguable for a diversified portfolio of equities.
Of course, far too few investors realize this. Even the few who do understand this often have trouble taking action when the market declines (i.e. buying opportunities arise).
Helping people further their understanding of these core investing principles by learning from the best investors in the world is the entire reason I started this newsletter.
Thanks for reading. I’ll be back next week with more timeless wisdom from great investors.
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