What are the risks investors should face up to?

risk

In Buffett’s 1993 shareholder letter, Buffett explained in detail the risks that stock market investors should face up to and why they should invest in the broader market index.

One good idea a year

Charlie and I decided long ago that in an investment lifetime it’s just too hard to make hundreds of smart decisions. That judgment became ever more compelling as Berkshire’s capital mushroomed and the universe of investments that could significantly affect our results shrank dramatically. Therefore, we adopted a strategy that required our being smart – and not too smart at that – only a very few times. Indeed, we’ll now settle for one good idea a year. (Charlie says it’s my turn.)

The definition of risk

The strategy we’ve adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it. In stating this opinion, we define risk, using dictionary terms, as “the possibility of loss or injury.”

Beta

Academics, however, like to define investment “risk” differently, averring that it is the relative volatility of a stock or portfolio of stocks – that is, their volatility as compared to that of a large universe of stocks. Employing data bases and statistical skills, these academics compute with precision the “beta” of a stock – its relative volatility in the past – and then build arcane investment and capital-allocation theories around this calculation. In their hunger for a single statistic to measure risk, however, they forget a fundamental principle: It is better to be approximately right than precisely wrong.

Risks that should be assessed

In our opinion, the real risk that an investor must assess is whether his aggregate after-tax receipts from an investment (including those he receives on sale) will, over his prospective holding period, give him at least as much purchasing power as he had to begin with, plus a modest rate of interest on that initial stake. Though this risk cannot be calculated with engineering precision, it can in some cases be judged with a degree of accuracy that is useful. The primary factors bearing upon this evaluation are:

  • 1) The certainty with which the long-term economic characteristics of the business can be evaluated;
  • 2) The certainty with which management can be evaluated, both as to its ability to realize the full potential of the business and to wisely employ its cash flows;
  • 3) The certainty with which management can be counted on to channel the rewards from the business to the shareholders rather than to itself;
  • 4) The purchase price of the business;
  • 5) The levels of taxation and inflation that will be experienced and that will determine the degree by which an investor’s purchasing-power return is reduced from his gross return.

It’s not easy to figure out

These factors will probably strike many analysts as unbearably fuzzy, since they cannot be extracted from a data base of any kind. But the difficulty of precisely quantifying these matters does not negate their importance nor is it insuperable. Just as Justice Stewart found it impossible to formulate a test for obscenity but nevertheless asserted, “I know it when I see it,” so also can investors – in an inexact but useful way – “see” the risks inherent in certain investments without reference to complex equations or price histories.

Is it really so difficult to conclude that Coca-Cola and Gillette possess far less business risk over the long term than, say, any computer company or retailer? Worldwide, Coke sells about 44% of all soft drinks, and Gillette has more than a 60% share (in value) of the blade market. Leaving aside chewing gum, in which
Wrigley is dominant, I know of no other significant businesses in which the leading company has long enjoyed such global power.

Refuse to accept a single, huge bet

Of course, some investment strategies – for instance, our efforts in arbitrage over the years – require wide diversification. If significant risk exists in a single transaction, overall risk should be reduced by making that purchase one of many mutually-independent commitments. Thus, you may consciously purchase a risky investment – one that indeed has a significant possibility of causing loss or injury – if you believe that your gain, weighted for probabilities, considerably exceeds your loss, comparably weighted, and if you can commit to a number of similar, but unrelated opportunities.

Most venture capitalists employ this strategy. Should you choose to pursue this course, you should adopt the outlook of the casino that owns a roulette wheel, which will want to see lots of action because it is favored by probabilities, but will refuse to accept a single, huge bet.

Index investment suits most people

Another situation requiring wide diversification occurs when an investor who does not understand the economics of specific businesses nevertheless believes it in his interest to be a long-term owner of American industry. That investor should both own a large number of equities and space out his purchases. By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when “dumb” money acknowledges its limitations, it ceases to be dumb.

Regarding the investment in the large-cap index, please refer to my previous blog article “Most investors should invest ETFs tracking broad market“.

Active investors can build portfolio with 5-10 targets

On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk.

I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices – the businesses he understands best and that present the least risk, along with the greatest profit potential. In the words of the prophet Mae West: “Too much of a good thing can be wonderful.”

As for the number of stocks recommended by famous investment masters, please refer to my previous article “Why concentrated Investment?

risk
credit: mintos.com

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