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Buffett’s ‘excellent advice’ on viewing risk

As readers of this column know, I am a big fan of Warren Buffet and, more specifically, his writings in his annual report for Berkshire Hathaway.

I've read through the latest letter and it is full of excellent advice. In the current issue Warren focuses on giving investors a short lesson on investing: more specifically on what investing actually is and how investors should view risk.

In the section “The Basic Choices for Investors and the One We Strongly Prefer”, Warren walks through three types of investments and what an investor needs to consider.

He initially defines investing as “the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power after taxes have been paid on nominal gains in the future.

More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date”. The key here, of course, is that one maintains their purchasing power over time.

He also clarifies how an investor should view risk. He suggests that an investor should not view risk as “beta” which is merely a Wall Street term that measures the volatility of the price of a security, but rather the “reasoned probability of that investment causing the owner a loss of purchasing-power over his contemplated holding period”.

He goes further to state: “Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. And ….a non-fluctuating asset can be laden with risk”.

The true risk in investing is a permanent loss of capital. I have always found it silly to see random price changes (especially those in a short time frame) as a “risk” measure so I would agree with Warren's assessment. (Note: Warren suggests reading Chapter Eight of Ben Graham's The Intelligent Investor to help mold how investors should view fluctuations in stock prices. I would highly recommend you do so if you haven't.)

Warren then precedes to breakdown the investing landscape into three simple categories. The first category is what he deems as “investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits and other instruments”. He goes on to state that these investments are typically “thought of as safe. In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge”. The last few years have made this category of investment very popular. The immense level of volatility and brash of negative news has unfortunately caused many investors to “over-weight” this category under the misguided guise that their wealth is being protected.

Unfortunately, these investments have, over a longer period of time, really destroyed purchasing power. Warren uses the example of the value of the dollar which has “fallen a staggering 86% in value since 1965.”

In fact it “takes $7 today to buy what $1 did at that time” and he adds that owners of these assets would have “needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power.

Managers would have been kidding themselves if they thought of any portion of that interest as “income”.

The comforting feeling of little price change in this category has deluded many investors to assume it is always safe. Currently owners here are simply giving up purchasing power in the long run to have more certainty in the short run.

The second category Warren discusses revolves around what he considers as unproductive assets. These assets succumb to the what is commonly referred to as the “greater fool theory” - they essentially derive their value on the “buyer's hope that someone else who knows that the asset will be forever unproductive will pay more for them in the future…Owners are not inspired by what the asset itself can produce it will remain lifeless forever but rather by the belief that others will desire it even more avidly in the future.”

Buffet, of course, places Tulips and gold in this category. To confess I have never personally understood gold fully. Many monetarists have created great theories and I have read so much on it in eloquently penned missives by brilliant writers but I still don't get it. I can't value it because it has no cash flows. If gold falls $500 is it cheaper? I don't know. In the end, Warren does a great job in summing up how some of these unproductive assets can escalate in price:

“….extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices. In these bubbles, an army of originally skeptical investors succumbed to the “proof” delivered by the market and the pool of buyers for a time expanded sufficiently to keep the bandwagon rolling…And then the old proverb is confirmed once again: “What the wise man does in the beginning, the fool does in the end””

I do not subscribe to the efficient market hypothesis the market at times, in my opinion, can be grossly wrong and the risk in unproductive assets being mispriced can be considerable.

The last category refers to what Warren calls “productive assets, whether businesses, farms, or real estate.” He suggests that these “have the ability in inflationary times to deliver output that will retain its purchasing-power value requiring a minimum of new capital investment. “

In essence, stock investing would be included in this category. Warren likens these investments to a cow that will live for many centuries and give “greater quantities of milk to boot.” He believes that “over any extended period of time this category of investing will prove to be the runaway winner among the three we've examined. More important, it will be by far the safest”.

As investors we tend to need money over longer periods of time. Whether you are saving for retirement or planning on being in retirement the time frame is often measured in decades. As a result it is very important to ensure your wealth is increasing to retain your future purchasing power.

In my opinion, the massive drop in common stock ownership since 1999 can be attributed to how investors perceive risk.

If one believes Warren, it may be far more intelligent to accept the possibility of loss in the next 12 months to gain significant purchasing power over the next decade.

Disclaimer: This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by Anchor Investment Management Ltd. to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the solediscretion of the reader. Investment involves risks. Readers should consult their financial advisors prior to any investment decision.

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Published March 12, 2012 at 2:00 am (Updated March 12, 2012 at 9:30 am)

Buffett’s ‘excellent advice’ on viewing risk

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