Jun

23

The Investing Philosophy of Warren Buffett: Part 4

Filed Under Investing, Warren Buffett |


This is my fourth post in a series about Warren Buffett’s investing philosophy. If you haven’t read the first three parts yet, you might want to do so now. I am going to build on the concepts that I talked about previously.
Part 1
Part 2
Part 3

Understand risk.

Most investment thinking today is still dominated by a view of risk that makes very little sense – the idea that volatility is risky. Stocks go up and down, and we fret about it because we are bombarded with the idea that this makes stocks risky. This idea has been thoroughly developed by academic researchers over many decades, but it is helpful to understand why they use volatility as a measure of risk. The reason is simple: academicians use volatility (usually measured by the variance or standard deviation of returns) as a measure of risk because it is easy to measure precisely and therefore makes it easier for them to use to test their hypotheses. This measure of risk became so common among financial researchers that it soon was rarely challenged anymore. Once academicians became brainwashed with this idea of the equivalence of volatility and risk, it wasn’t long before they trained college graduates to believe it too. The research done by the academicians had an air of scientific precision, so it wasn’t difficult to convince students to ignore their own common sense. If “experts” think that volatility is a good measure of risk, who are we to disagree with them? Right? Wrong.

This is one area where the old view of investing is far superior to the current view. Investors used to think in terms of the dictionary definition of risk – “possibility of loss or injury” – which makes far more sense. As Warren Buffett wrote:

“In our opinion, the real risk that an investor must assess is whether his aggregate after-tax receipts from an investment (including those he receives on sale) will, over his prospective holding period, give him at least as much purchasing power as he had to begin with, plus a modest rate of interest on that initial stake.  Though this risk cannot be calculated with engineering precision, it can in some cases be judged with a degree of accuracy that is useful.”
1993 Letter to Berkshire Hathaway shareholders

What does Buffett mean? In simpler terms, he means that we should assess the probability that an investment won’t leave us with more money in the future (after adjusting for inflation) than we have now.

If you instead use volatility as a measure of risk, you could reach some absurd conclusions. For example, if you look at the annual volatility of the stock market (say the S&P 500 Index), you will notice that it is much higher than the annual volatility of money market funds.  From this, you could easily come to the erroneous conclusion that the stock market is much riskier than money market funds. This is a foolish conclusion because it ignores your prospective holding period. If you bought shares in an S&P 500 Index fund and held it for 30 years, this would be far less risky than investing in money market funds and holding it for 30 years. The reason for this is because you are virtually guaranteed to lose money on the money market fund after adjusting for taxes and inflation, whereas the S&P 500 Index fund would virtually guarantee that you would earn positive inflation-adjusted after-tax returns. What seems riskier to you? The money market fund that will virtually guarantee a loss, or the S&P 500 Index fund that will virtually guarantee a gain? The answer is obvious and should clarify why volatility is a poor measure of risk.

Another absurd conclusion that results from using volatility as a measure of risk is the idea that an investment that has suddenly dropped in price is now riskier than it was previously because it is now more volatile. Suppose you were considering buying the stock of ABC Company. Would buying at $25 be just as risky as buying it at $50? Using volatility as a measure of risk, the two prices would have identical risk, but this is a ludicrous view of risk. We aren’t concerned with volatility, per se. We are concerned with the possibility of losing money (or not achieving a satisfactory return). The problem is that volatility doesn’t tell us the extent to which we are in danger of losing money. It just tells us how much the investment’s returns have moved up and down in the past.

To be continued…


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1 Comment so far

  1. Dean Morel on July 5, 2008 8:01 am

    Hi Mark,
    Excellent series thus far on Buffett. I’m enjoying reading it.
    I like this new theme you have as well; simple clear and attractive.