Finance News

Warren Buffett on Risk and Reward

The price paid must always provide an adequate margin of safety

April 16, 2020

The current Covid-19-induced market jolt, which saw the shares of many stable companies drop by over 30%, provides an excellent backdrop for discussing the concept of risk and reward. Some stalwart investors may argue that now is a good time to buy because prices are depressed and the overall market has entered bear territory.

Warren Buffett (Trades, Portfolio)’s likely response to the question whether or not now is a good time to buy, when prices are depressed, would be no different than his answer to the same question were it asked when the market was hitting new highs. As a disciple of Benjamin Graham, Buffett would undoubtedly reply that the wisdom of purchasing stocks in the current depressed conditions depends on the company in question; to wit, the current depressed price of its stock still may or may not be a good indicator of the worth of its underlying business.

For Buffet, the condition of the overall market at any given time is irrelevant in making an intelligent investment decision.

In his 1984 article, “The Superinvestors of Graham-and-Doddsville,” Buffet offered this analogy for how one ought to characterize the risk of purchasing a stock, first by characterizing a common but fallacious market risk scenario:

“I would like to say one important thing about risk and reward. Sometimes risk and reward are correlated in a positive fashion. If someone were to say to me, ‘I have here a six-shooter and I have slipped one cartridge into it. Why don’t you just spin it and pull it once? If you survive, I will give you $1 million.’ I would decline — perhaps stating that $1 million is not enough. Then he might offer me $5 million to pull the trigger twice — now that would be a positive correlation between risk and reward!”

Buffett then follows up this rather gruesome example of risk, with the following hypothetical by way of contrast:

“The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it’s riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is.”

Buffett distinguishes the concept of market risk with his steadfast belief that real risk is discerning the chasm between the worth of the underlying business and its share price, which at any given time could vacillate with the market as a whole or have no rational relationship to its current price. Buffet states that those who can ascertain the discrepancy and, therefore, the concomitant level of risk, will be capable of making informed investment decisions. He wrote:

“These Graham-and-Doddsville investors have successfully exploited gaps between price and value. When the price of a stock can be influenced by a “herd” on Wall Street with prices set at the margin by the most

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emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical.”

Successful investors will always purchase with a margin of safety, sufficient with which to ensure that their principal investment will not be lost. The ability to purchase a stock with a price that will provide a margin of safety is what, in the end, for Buffett defines risk.

Buffett offers a pertinent example of how to incorporate margin of safety analysis in determining if the price paid will adequately guard against the risk of total loss

“You don’t try to buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And that same principle works in investing.”

In the end, since market movements don’t determine risk, where does risk come from?

Buffett’s answer?

“Risk comes from not knowing what you’re doing.”

About the author:

John Kinsellagh

John Kinsellagh is a financial writer, former financial advisor and attorney, with over twenty-years experience in civil litigation and securities law. He completed the Boston Security Analysts Society course on Investment Analysis and Portfolio Management.

He has served as an arbitrator for FINRA for over 25 years resolving disputes within the financial services industry. He writes primarily on financial markets, legal and regulatory issues that impact the investment community, and personal finance.

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