Warren Buffett and the 'Degree of Difficultly' in Investing

There's no extra reward for taking on more risk as an investor

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Mar 23, 2021
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Earlier this week, I discussed the different strategies hedge fund managers have used to achieve market-beating returns.

The point of the discussion was to illustrate the fact there are many different ways to make money in the market. Investors should never feel pressured to use one particular strategy or invest in a specific sector.

What really matters is how comfortable an investor feels following a particular strategy and whether or not they understand it. Investing in something one does not understand is the easiest way to lose money.

Warren Buffett (Trades, Portfolio) introduced a similar way of thinking at Berkshire Hathaway's (BRK.A, Financial) (BRK.B, Financial) 2005 annual meeting of shareholders. The Oracle of Omaha stated that there is no "degree of difficulty" adjustment in investing, meaning that investors are not necessarily compensated for taking on more risk or complexity.

The degree of difficultly

At Berkshire's 2005 annual meeting, one investor asked Buffett for his thoughts on the pharmaceutical industry.

Berkshire's CEO explained that the industry has been historically quite profitable and earned "very good returns on invested capital."

However, he added that he didn't want to speculate on what the future held for pharmaceutical stocks as he did not understand the industry and the challenges and opportunities it faced.

His right-hand man,

Charlie Munger (Trades, Portfolio), added that sometimes it's better to throw something in the "too hard" pile than try and figure it out.

Buffett took over at this point and went on to add some more color to this principle. He stated that one of the exciting things about investing is that "there's no degree of difficulty factor."

For example, in many other fields, experience is rewarded with a higher level of return. The example Buffett gave at the interview was that of an Olympic diver, who was awarded more points for completing a more complex routine.

That's not the only example. Graduates with better degrees tend to be paid more, and employees who have more experience are usually rewarded with more responsibility, which comes with a higher level of compensation.

In all three of these cases, it is not easy to achieve the highest status level. Discipline and consistency are required to move up a level, so to speak, and this discipline and consistency are rewarded with a higher level of compensation.

There's no such reward in investing. As Buffett explained:

"But in terms of investing, there is no degree of difficulty. If something is staring you right in the face and the easiest decision in the world, the payoff, can be huge. And we get paid, not for jumping over 7-foot bars, but for stepping over 1-foot bars. And the biggest thing we have to do is decide which ones are the 1-foot bars and which ones are the 7-foot bars so when we go to step we don't bump into the bar. And that is something that I think we're reasonably good at."

By following this approach, Buffett may end up missing out on attractive opportunities. Still, he said he would rather miss out on these opportunities than be exposed to losses that may come as a result of investing in something he does not understand:

"Now maybe we cast out too many things as being too hard and thereby narrow our universe. But I'd rather have the narrow — the universe be a little too — interpret it as being a little too — a little smaller than it really is, than being interpreted as larger than it is."

There are many different ways to make money in the stock market. One does not have to overcomplicate the process to achieve a good return.

Disclosure: The author owns no stocks mentioned.

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