Trying to define and quantify investment risk is a difficult task for any investor or trader. Calculating the risk of a portfolio at any given point in time relies on many different variables, which ultimately mean nothing if calculated with incorrect data, a data sample that is too small or if humans just decide to act irrationally. For value investors, however, trying to define investment risk should be relatively easy compared to the rest of the market participants.
Rather than trying to determine risk by using complicated computer models, value investors should be assessing individual company risk according to the risk of permanent capital impairment, not stock volatility. To help explain the value investor's concept of risk, I have drawn together some quotes from two of the most famous value investors of all time, Warren Buffett (Trades, Portfolio) and Benjamin Graham.
Buffet at Berkshire Hathaway’s (BRK.A, Financial)(BRK.B, Financial) 2007 annual meeting:
“The measurement of volatility: it’s nice, it’s mathematical and wrong. Volatility 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. [Measures like] beta let people who teach finance use the math they’ve learned. That’s nonsense. Risk comes from not knowing what you’re doing. Dexter Shoes was a terrible mistake-I was wrong about the business, but not because shoe prices were volatile. If you understand the business you own, you’re not taking risk. Volatility is useful for people who want a career in teaching. I cannot recall a case where we lost a lot of money due to volatility. The whole concept of volatility as a measure of risk has developed in my lifetime and isn’t any use to us.”Â
“I would like to say one important thing about risk and reward. Sometimes risk and reward are correlated in a positive fashion. If someone were to say to me, 'I have here a six-shooter and I have slipped one cartridge into it. Why don’t you just spin it and pull it once? If you survive, I will give you $1 million.' I would decline — perhaps stating that $1 million is not enough. Then he might offer me $5 million to pull the trigger twice — now that would be a positive correlation between risk and reward!
The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it’s riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is.”
Buffett's 2015 annual letter:
“Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments — far riskier investments — than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.”
Buffet in Berkshire Hathaway’s 1993 annual shareholder letter:
“We define risk, using the dictionary terms, as 'the possibility of loss or injury.' Academics…like to define investment 'risk' differently, averring that it is the relative volatility of a stock or portfolio of stocks… Compared to a large universe of stocks. Employing databases and statistical skills, these academics compute with precision the 'beta' of a stock…and then build… Investment and capital allocation theories around this calculation…for a single statistic to measure risk…for the owners of a business--and that’s the way we think of shareholders, the academics’ definition of risk is far off the mark.”
Graham:
“Beta is a more or less useful measure of past price fluctuations of common stocks. What bothers me is that authorities now equate the beta idea with the concept of risk. Price variability yes; risk no. Real investment risk is measured not by the percent that a stock may decline in price in relation to the general market in a given period, but by the danger of a loss of quality and earnings power through economic changes or deterioration in management.”
While the final quote is short, it is perhaps the most important statement Buffett has ever issued on the topic of risk:
“Risk comes from not knowing what you're doing.”
A simple statement, but not one any investor should ignore.
Disclosure: The author owns no stock mentioned.
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