Being able to understand and correctly assess risk in an investment scenario is vital for long-term investing success. This is something Warren Buffett (Trades, Portfolio) has understood from the very beginning of his investment career. Losing money slows down compounding, which makes it harder to get rich. Therefore, permanent capital losses should be avoided at all costs.
With this being the case, it might surprise you to learn that Buffett and his right-hand man, Charlie Munger (Trades, Portfolio), have no set formula for assessing investment risk.
The duo tackled this topic at the 2019 Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) annual meeting of shareholders. One shareholder wanted to know if the legendary investors could shed any light on their "risk evaluation approach," and how they balance risk analysis with the "perseverance and determination and grit that are often necessary for success."
Buffett started responding to the question by saying that the Berkshire managers "don't have any formula that evaluates risk," but that they do "make our own calculation of risk versus reward in every transaction we do."
He went on to add:
"And that's true whether it's marketable securities, that's true whether it's private investments, that's true whether it's making an investment in a business. And sometimes we're wrong, and we're going to be wrong sometimes in the future. You can't make a lot of decisions in this business without being wrong."
The Oracle of Omaha then went on to explain that he does not believe that any investor or group of investors would be able to reduce risk by spending hours and hours trying to reduce risk. Instead, such an approach might actually increase the chances of making a mistake because a group of analysts would "tell me what I wanted to hear."
Here's the full quote:
"But we don't think the procedure — or the results — would be changed favorably by having lots of committees and lots of spreadsheets and that sort of thing. It just — you know — If I had a group under me, they would try and figure out what I wanted the answer to be, and they would tell me what I wanted to hear. And I've watched that approach at 20 public companies."
The key, according to Buffett, is that you need to be sure you understand a business and its operations. He compared the process to insurance. With insurance, when you're underwriting a deal, you need to be "reasonably sure that you know what you're doing." Once you've checked that box, "go on to figure out the math of gain versus loss and how much loss we can afford to take in anything."
From here, it is a simple risk versus reward analysis. Is the risk worth taking for the potential reward on offer? If so, then it is a good deal.
If that process seems straightforward, it's because it is. As Buffett said, there are no complicated formulas at Berkshire because he does not need them, and adding them in would only complicate the process. If a deal looks like good value at first glance, without spending hours looking at spreadsheets to make the numbers work, then Buffett is interested. There's no need to complicate the process further.
"We don't sit down and write a bunch, you know — have people work to midnight calculating things and putting spreadsheets together. And if the hurdle rate is 15% or something, having them all come out at 15.1 or 15.2, because that's what's going to happen. I mean, you're going to get the numbers you want to hear and to an extreme degree."
Disclosure: The author owns shares of Berkshire Hathaway.
Read more here:
- Mohnish Pabrai: Why Investors Should Operate Alone
- Bank of America May Be Buffett's Favorite Stock in an Overvalued Market
- Walter Schloss on Buffett's Big Mistake
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