The question of how to define and quantify risk has befuddled many an investor. Humans naturally feel more comfortable assigning a number to the concept of risk, as it gives them a degree of certainty. However, this is often a false sense of security. Just because something has some numerical value doesn’t mean that it is a true representation of reality. In fact, by assuming a higher degree of certainty than can actually be measured, you run the risk of misjudging your risk entirely. Never mistake the map for the territory. This was an idea addressed by Warren Buffett (Trades, Portfolio) at Berkshire Hathaway’s (BRK.A, Financial)(BRK.B, Financial) 2007 annual shareholder meeting.
Nice and mathematical and wrong
“Volatility is not a measure of risk. And the problem is that the people who have written and taught about volatility do not know how to measure — or, I mean, taught about risk — do not know how to measure risk. And the nice about beta, which is a measure of volatility, is that it’s nice and mathematical and wrong in terms of measuring risk. It’s a measure of volatility, but past volatility does not determine the risk of investing.”
Buffett is also of the opinion that just because something is precise and mathematical, it's not necessarily right. He illustrated this point with an example about farmland:
“I mean, actually, take it with farmland. Here in 1980, or in the early 1980s, farms that sold for $2,000 an acre went to $600 an acre. I bought one of the them when the banking and farm crash took place. And the beta of farms shot way up. And according to standard economic theory or market theory, I was buying a much more risk asset at $600 an acre than the same farm was at $2,000 an acre.
Now, people, because farmland doesn’t trade often and prices don’t get recorded, you know, they would regard that as nonsense, that my purchase at $600 an acre of the same farm that sold for 2,000 an acre a few years ago was riskier. But in stocks, because the prices jiggle around every minute, and because it lets the people who teach finance use the mathematics they’ve learned, they have — in effect, they would explain this a way a little more technically — but they have, in effect, translated volatility into all kinds of — past volatility — in terms of all kinds of measures of risk.”
So if beta and volatility are not risk, then what IS risk? Buffett explained that risk arise is a result of not knowing the potential pitfalls of the venture you are embarking on. If you are well informed and have done your research, you bear little risk:
“Risk comes from the nature of certain kinds of businesses. It can be risky to be in some businesses just by the simple economics of the type of business you’re in, and it comes from not knowing what you’re doing. And, you know, if you understand the economics of the business in which you are engaged, and you know the people with whom you’re doing business, and you know the price you pay is sensible, you don’t run any real risk.”
This measure of risk is harder to express as a number than the concept of beta, which is why it is disliked by many academics and economists. That may be true, but when it comes to investing, we will side with the practitioners over the theorists.
Disclosure: The author owns no stocks mentioned.
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