Berkshire Hathaway 2002 Annual Meeting Audience Question # 24

The difference between investing and speculating

Warren Buffett:

And the second part of the question?

Audience Member:

Thank you, sir. The second part of my question is this: given your assumptions on gold, if you were to factor a significant decline in the value of the dollar against gold, let’s say 40 percent or more, and given the correlation of 1929-’48 and ‘64-’81 eras positively to the decline of the dollar, and the negative correlation in the other two areas that you had studied, would you care to adjust the 7 percent total annual return you were quoted as expecting for common equity in the coming decade?

And in conjunction with that, would you care to comment on your expected rate or return on all other major asset classes, perhaps like bonds, real estates? And which would you believe offers the best value for investors? Thank you very much.

Warren Buffett:

Yeah. Well, except under unusual circumstances, my expected rate… my expectancy on something like bonds is what bonds are producing at a given time. I don’t think I’m smarter than the bond market.

Now, you can say, when they… when those rates swing all over, does that mean I swing all over? The answer is pretty close to yes. I mean, that… I don’t know what the right rate for bonds is. I think that if there’s…

I’m very leery of economic correlations. I mean, I spent years fooling around with that sort of thing, and I mean, I correlated stock prices with everything in the world. And the… and you know, the problem was when I found a correlation.

I mean, it’s… you know, you’ve seen these things on whether the AFC or the NFL wins the Super Bowl and all of that sort of thing.

You can find something that correlates with something else.

But in the end, a business or any economic asset is going to be worth what it produces in the way of cash over its lifetime.

And if you own a… if you own an oil field, if you own a farm, if you own an apartment house, you know, with the oil field, it’s the life of the oil field and what you can get out of it. And maybe you get secondary recovery, maybe you get tertiary recovery.

But whatever it may be, it’s worth the discounted value of the oil that’s going to come out. And then you have to make an estimate as to volume and as to price.

With a farm, you might make an estimate as to crop yield, and cost, and crop prices.

And the apartment house, you make an estimate as to rentals, and operating expenses, and how long it’ll last, and when people will build other new apartment houses that potential renters in the future will find preferable, and so on.

But all investment is, is laying out some money now to get more money back in the future. Now, there’s two ways of looking at the getting the money back. One is from what the asset itself will produce. That’s investment.

One is from what somebody else will pay you for it later on, irrespective of what the asset produces, and I call that speculation.

So, if you are looking to the asset itself, you don’t care about the quote because the asset is going to produce the money for you.

And that’s how… that’s what society, as a whole, is going to get from investing in that asset.

Then there’s the other way of looking at it, is what somebody will pay you tomorrow for it, even if it’s valueless. And that’s speculation. And of course, society gets nothing out of that eventually, but one group profits at the expense of another.

And of course, you had that operate in a huge way in the bubble of a few years ago. You had all kinds of things that were going to produce nothing, but where you had great amounts of wealth transfer in the short term.

As investments, you know, they were a disaster. As means of wealth transfer, they were terrific for certain people. And they were, for the other people that were on the other side of the wealth transfer, they were disasters.

We look solely… we don’t care whether something’s quoted because we’re not… we don’t buy it with the idea of selling it to somebody. We look at what the business itself will produce.

Charlie Munger:

Yeah, what makes common stock prices so hard to predict is that a general liquid market for common stocks creates, from time to time, either in sectors of the market or in the whole market, a Ponzi scheme.

In other words, you have an automatic process where people get sucked in and other people come in because it worked last month or last year. And it can build to perfectly ridiculous levels, and the levels can last for considerable periods.

Trying to predict that kind of thing, sort of a Ponzi scheme which is, if you will, accidentally thrown into the valuation of common stocks by just the forces of life, by definition that’s going to be very, very hard to predict. But that’s what makes it so dangerous to short stocks, even when they’re grossly overvalued.

It’s hard to know just how overvalued they can become in addition to the overvaluation that exists. And I don’t think you’re going to predict the Ponzi scheme effect in markets by looking at the price of gold or any other correlation.

Warren Buffett:

Charlie and I probably… I mean, I’m pulling a figure out of the air… we have probably agreed on at least a hundred companies, maybe more, that we felt were frauds, you know, bubble-type things.

And if we had acted on shorting those over the years, we might be broke now, but we were right on probably just about a hundred out of a hundred. It’s very hard to predict how far what Charlie calls the Ponzi scheme will go.

It’s not exactly a scheme in the sense that it isn’t concocted, for most cases, by one person. It’s sort of a natural phenomenon that seems to… nursed along by promoters and investment bankers and venture capitalists and so on. But they don’t all sit in a room and work it out.

It just… it plays on human nature in certain ways and it creates its own momentum, and eventually it pops, you know. And nobody knows when it’s going to pop, and that’s why you can’t short, at least we don’t find it makes good sense to short those things.

But they are… it is recognizable. You know when you’re dealing with those kind of crazy things, but you don’t know when the… how high they’ll go or when it’ll end or anything else.

And people who think they do, you know, sometimes play in it. And other people know how to take advantage of it, I mean there’s no question about that.

You do not have to have a 200 IQ to see a period like that and figure out how to have a big wealth transfer from somebody else to you, you know. And that was done on a huge scale, you know, in recent years. It’s not the, you know… it’s not the most admirable aspect of capitalism.

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