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How Warren Buffett Defines Risk

August 28th, 2014

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This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

Risk comes from not knowing what you're doing. - Warren Buffett

If you mention Buffett's quote above to most people, you'll likely get a nod that says "oooh, that's deep". But if you ask them what they think it means, you will likely get confused stares.

In this article, I will explain what Buffett means when he says risk comes from ignorance. In fact, this quote reveals the way we see risk, and how he sees it differently from how many other people see risk.

Shortcomings Of The Traditional Measure Of Risk

As readers of my free book know, investment professionals normally measure risk using standard deviation. Standard deviation basically measures the degree of ups and downs of a stock. For example, if a stock goes up or down by roughly 5% every day, that stock has a higher standard deviation than a stock that goes up or down by 1% every day.

Most investment professionals see stocks with higher standard deviation as carrying higher risk. To understand why, imagine that you had to sell your stocks tomorrow. Do you feel safer holding stocks that might go down 5%? Or do you feel safer holding stocks that might go down just 1%?

Even if you don't intend to sell your stocks tomorrow or even the next month or year, the value of your holdings is measured by how much they would sell for at today's prices. Most people start to feel anxious if the value of their holdings goes up and down dramatically.

However, Warren Buffett fundamentally disagrees with this definition of risk. In Berkshire Hathaway's 2007 annual meeting, he had this to say.

It's nice, it's mathematical, and wrong. Volatility (i.e. standard deviation) is not risk.Those who have written about risk don't know how to measure risk. Past volatility does not measure risk. When farm prices crashed, [farm price] volatility went up, but a farm priced at $600 per acre that was formerly $2,000 per acre isn't riskier because it's more volatile. - Warren Buffett

Let me explain what he means.

Let's say you had a farm, and you could reasonably expect to make $200/acre every year using the land. Let's say that for many years, the price of the farm fluctuated around $1,900 to $2,100. In other words, it exhibited low standard deviations.

However, let's say that one year, prices became very volatile and farm prices crashed to $600. However, in the long term, the farm is still expected to generate $200/acre every year.

Here's the question: Is the farm riskier because its price crashed to $600?

If you measured risk by standard deviation, the answer would be yes. However, common sense would tell us that far from being riskier, the farm was actually a lot less risky as an investment.

If you could buy the farm at $600, then it wouldn't actually take much to generate a healthy return on your investment. For example, even if the farm became decidedly less profitable and only generated $50/acre every year, the farm would still prove to be a good investment that returns above 8% per year. However, if you had bought the farm at $2,000, then $50/acre a year would represent poor returns on investment.

A Safe Company That Looked Risky

What applies to farms applies to corporations as well. I'll give you a real example.

In late 2008, as the stock market crashed, a tiny company called Coopers Parksaw its stock prices crash as well. Its stock price went from around 70 cents a share in late 2007, to just 5 cents a share by the end of 2008 - a 93% loss. As if that wasn't enough, by April 2009, the stock hit a low of 2 cents a share, a 60% loss from the end of 2008 and a 97% loss since late 2007. At this point, the company was valued at just $1.8 million.

If you measured the riskiness of this company using standard deviation, the risk level would have been off the charts. However, if you bothered to look at their financial statements and used some common sense, you would have seen that this company was about the safest investment you could make.

If you read the financial statements, you will have noticed a few things on their balance sheet (i.e. their list of assets and debts). At the end of March 2009, they carried $39 million worth of property and $46 million in cash. Against this, the company had $9 million in accounts payable (i.e. short term debt) and $5.4 million in taxes payable. The company carried no other debt.

In other words, if the company paid off all their debt and taxes, they would still have been left with some $32 million dollars in cash alone, not to mention the $39 million in property! Yet the whole company was trading for under $2 million.

Nothing is safer than cash. Unless they're lying about how much cash they had in the bank, this was possibly the safest investment you could make at the time. (For the record, Coopers Park shares rose back above 70 cents, and yes, I made some money on the way up).

The True Source Of Risk

Buffett argues that if you intend to hold an investment for a long time, it doesn't make sense to measure risk by standard deviation. If you're not going to sell your investments anytime soon, what prices do in the near term should have no bearing on risk.

Instead, Buffett makes the case that risk really comes from possible deterioration of business fundamentals.

As an example, Buffett sometimes quotes his example of Dexter Shoes. In summary, Buffett bought Dexter thinking that the shoe company will continue to generate healthy profits. Unfortunately, competition from overseas led to a price war, which Dexter lost.

When you think about such business risks, you realize that you can anticipate, or at least become aware of such risks. This becomes clear when you think about the major businesses you know that have declined in value, and understand why they declined in value.

For example, Blackberry's business dramatically declined because they failed to keep up with the competition. But the warning signs were clearly there long before the stock price declined. In 2008 when Blackberry stocks were flying high, many analysts were writing about the potential disruption from Apple's iPhone. Someone like Buffett would never have bought Blackberry shares, because competition clouded the future of the company. In other words, there was risk in not knowing what the future looked like. It's the same reason why I won't touch Apple shares today.

The same goes for Yellow Pages, now called Yellow Media. Back in the day, Yellow Pages possessed a very profitable natural monopoly. But anyone with an internet connection could see that Yellow Pages' bread and butter business was at risk.

As a final example, think about Enron. While the general populace was loading up on Enron shares, people like Jim Chanos did his due diligence and actually bet against the company. Through careful scrutiny of financial statements, he could see that Enron was a scam.

Therefore, for the long term shareholder, most of the risk from buying stocks didn't come from completely unexpected turns of events. But rather, it comes from not doing the proper due diligence and not understanding the business completely. This is what Buffett means when he says that "Risk comes from not knowing what you're doing".

Why We Still Use Standard Deviation

If you've read this far, you might wonder: if I really believe this, then why do I talk about standard deviation as a measure of risk in my free book as well as my free course? I do it for 2 reasons.

First, in general (but not always), risky stocks come with high standard deviations. If you look at J C Penney, for example, its stock price moves up and down quite violently (i.e. has high standard deviations). That's because as J C Penny oscillates between making profit and losing money, the opinion on the company shifts often.

Second, while I believe short term price fluctuations don't matter, I recognize that most people have trouble thinking the same way. Most people do feel anxious when stock prices take a temporary hit, which often causes them to make bad decisions. For example, during the depth of the financial crisis, many people sold their stocks out of fear, though they should have been buying stocks instead.

I don't want to ignore the emotional reality of people, which is why I try to optimize the portfolios in such way that the portfolios don't move up and down very much. That's why I will continue to pay attention to standard deviation, even though quite frankly, I don't care about it much for my own portfolio.

This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.