Berkshire Hathaway 1994 Annual Meeting Audience Question # 39

How Warren views and calculates risk

Warren Buffett:

Zone 5.

Audience Member:

Hello, my name is Charles Pyle from Ann Arbor, Michigan.

I’d like to ask you to expound on your view of risk in the financial world, and I ask that against the background of what appear to be a number of inconsistencies between your view of risk and the conventional view of risk.

I mention that in a recent article you pointed out inconsistency in the use of beta as a measure of risk, which is a common standard.

And I mention that derivatives are dangerous, and yet you feel comfortable playing at derivatives through Salomon Brothers. And betting on hurricanes is dangerous, and yet you feel comfortable playing with hurricanes through insurance companies.

So it appears that you have some view of risk that’s inconsistent with what would appear on the face of it to be the conventional view of risk.

Warren Buffett:

Well, we do define risk as the possibility of harm or injury. And in that respect we think it’s inextricably wound up in your time horizon for holding an asset.

I mean, if your risk is that you’re going… if you intend to buy XYZ Corporation at 11:30 this morning and sell it out before the close today, I mean, that is, in our view, that is a very risky transaction. Because we think 50 percent of the time you’re going to suffer some harm or injury.

If you have a time horizon on a business, we think the risk of buying something like Coca-Cola at the price we bought it at a few years ago is essentially, is so close to nil, in terms of our perspective holding period. But if you asked me the risk of buying Coca-Cola this morning and you’re going to sell it tomorrow morning, I say that is a very risky transaction.

Now, as I pointed out in the annual report, it became very fashionable in the academic world, and then that spilled over into the financial markets, to define risk in terms of volatility, of which beta became a measure.

But that is no measure of risk to us. The risk, in terms of our super-cat business, is not that we lose money in any given year. We know we’re going to lose money in some given day, that is for certain. And we’re extremely likely to lose money in a given year.

Our time horizon of writing that business, you know, would be at least a decade. And we think the probability of losing money over a decade is low. So we feel that, in terms of our horizon of investment, that that is not a risky business. And it’s a whole lot less risky than writing something that’s much more predictable.

Interesting thing is that using conventional measures of risk, something whose return varies from year to year between plus-20 percent and plus-80 percent is riskier, as defined, than something whose return is 5 percent a year every year.

We just think the financial world has gone haywire in terms of measures of risk.

We look at what we do… we are perfectly willing to lose money on a given transaction, arbitrage being an example, any given insurance policy being another example. We are perfectly willing to lose money on any given transaction.

We are not willing to enter into transactions in which we think the probability of doing a number of mutually independent events, but of a similar type, has an expectancy of loss. And we hope that we are entering into our transactions where our calculations of those probabilities have validity.

And to do so, we try to narrow it down. There are a whole bunch of things we just won’t do because we don’t think we can write the equation on them.

But we, basically, Charlie and I by nature are pretty risk-averse. But we are very willing to enter into transactions…

We, if we knew it was an honest coin, and someone wanted to give us seven-to-five or something of the sort on one flip, how much of Berkshire’s net worth would we put on that flip?

Well we would… it would sound like a big number to you. It would not be a huge percentage of the net worth, but it would be a significant number. We will do things when probabilities favor us.

Charlie?

Charlie Munger:

Yeah, we, I would say we try and think like Fermat and Pascal as if they’d never heard of modern finance theory.

I really think that a lot of modern finance theory can only be described as disgusting.

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