The Rational Investor #053: Buffett on Volatility As Risk
Happy Saturday to you,
Welcome to the 53rd edition of The Rational Investor Newsletter!
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This week’s quote comes from the book University of Berkshire Hathaway: 30 Years of Lessons Learned from Warren Buffett and Charlie Munger by Daniel Pecaut and Corey Wrenn. The two authors spent thirty years attending the Berkshire annual shareholders’ meeting and kept notes of what they had learned over the years. The book is a copy of their notes. If you enjoy Buffett, you’ll enjoy this book.
So, without further ado, here we go…
Here’s Warren Buffett on Volatility as Risk [Italics are of the Author]:
“In modern portfolio theory, beta is a measure of volatility, which, in turn, is seen as a measure of 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 say the ‘beta’ of farms went way up, so you would be taking far more risk buying it at $600 (as Buffett did) than at $2,000/acre.
That, of course, is nonsense. But stocks do trade, and math types like the ability of computers to model 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.
For example, Buffett noted that he’s willing to lose $6 billion in one catastrophe, but Berkshire’s insurance business over time is not very risky. Given time, the probabilities will play out. Similarly, if you own a roulette wheel, you sometimes have to pay 35 to 1, but that’s okay. He’d love to own a lot of roulette wheels.
Munger put 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.’”
As Buffett makes obvious in his farm and roulette examples, volatility—at least on its own—is not risk. Howard Marks has said that volatility may be an indication of the presence of risk, but it is not, in and of itself, risk.
Understanding this distinction is critical to being a successful investor.
It’s easy to be convinced that volatility and risk are synonymous given that market volatility is a near-constant topic in the media. They love to talk about it because it raises TV ratings, and it is ever-present given that the market tends to decline by an average of 14% per year, and bear markets appear about once out of every 4/5 years.
Yet, despite all that volatility, the market was at 60 in 1960 and stands near 6,000 today, not including dividends. That should be enough to convince nearly anyone that it’s not the market that is risky, it is the investor himself who is the real risk to their long-term plan.
That’s what Buffett was getting at when he said,
“Real risk comes from not knowing what you’re doing.”
Of course, it’s possible that this is the end of the road for equities. But I’ll bet on history.
That’s all for this week. Thanks for reading. I’ll be back next week with more timeless wisdom from great investors.
