In his superb article, The Superinvestors of Graham-and-Doddsville, Warren had this to say about beta:
“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!"
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.
One quick example: The Washington Post Company in 1973 was selling for $80 million in the market. At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more. The company owned the Post, Newsweek, plus several television stations in major markets. Those same properties are worth $2 billion now, so the person who would have paid $400 million would not have been crazy.
Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta would have been greater. And to people that think beta measures risk, the cheaper price would have made it look riskier. This is truly Alice in Wonderland. I have never been able to figure out why it’s riskier to buy $400 million worth of properties for $40 million than $80 million. And, as a matter of fact, if you buy a group of such securities and you know anything at all about business valuation, there is essentially no risk in buying $400 million for $80 million, particularly if you do it by buying ten $40 million piles of $8 million each. Since you don’t have your hands on the $400 million, you want to be sure you are in with honest and reasonably competent people, but that’s not a difficult job.”
So what is risk according to Warren Buffett?
Warren Buffett says “Don’t worry about risk the way it is taught at Wharton. Risk is a go/no go signal for us – if it has risk, we just don’t go ahead.”
According to Buffett, risk is exactly as the Merriam-Webster dictionary defines it:
“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.‘”
So to Buffett, risk has nothing to do with volatility. Risk is simply the probability of losing your initial investment. If there is a chance that he might lose money on an investment, then Buffett simply doesn’t invest.
But where does risk come from then? Certainly not from stock prices.
The answer is simple:
“Risk comes from not knowing what you’re doing.” – Warren Buffett
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