I was discussing the concept of financial risk with a friend in the finance industry last night, and it seemed to me that our views on risk diverged somewhat. I thought of our discussion again this morning when I read a report of the recent annual pilgrimage to the sages of Omaha, Nebraska -- Mr Warren Buffett & Charlie Munger -- whose combined wisdom struck upon this very topic.
What my friend and I were discussing was the relationship between risk and return, and how exactly one measures or quantifies risk -- which is what, as it turns out, my friend is in the business of doing.
On these two issues, my friend insists 1)that risk can be measured (one simply looks at the past volatility of an investment vehicle and extrapolates it into the future, apparently), and 2) that returns necessarily bear a direct relationship to the risk of an investment -- which is pretty much the standard patter on risk these days. (Or as the Gnomes of Zurich have been known to say, "Worry is a sign of health: If you're not worried, then you're not risking enough." )
But why would you assume that past volatility alone is necessarily an accurate guide to future performance? Didn't help those investors in the likes of Brierley, for example, which went from blue chip (non-volatile) to dog (highly flammable) in the blink of a share ticker's tail a few years back.
And why should risk and return necessarily be correlated? A fairly successful friend maintains what to me seems a perfectly sensible view of risk and return, which is to seek those investments in which the risk of loss is low and the expected return very high. Sounds sensible to me. Seek out opportunities in which the risk is already low, and increase you margin of safety by having a high margin of safety when things go wrong, which they do. In other words, why not stop worrying altogether, while getting the same (or better) returns than your gnome over there with the ulcer?
We talked some more about this, my friend and I -- my friend who is in the business of calculating risk for investors -- and I was thinking about our conversation as I read this gem from two of the world's most successful investors:
Both men had lots of critical things to say about the so-called risk managers of our day. Risk managers, as the name implies, are supposed to ensure the safety and soundness of the investments made by financial institutions. "But too often," Buffett complained, "a risk manager is a guy who makes you feel good while you do dumb things."
Someone asked whether the big investment banks are too complex for even their managers to understand the risks the banks are exposed to. Buffett said: "Probably yes." He also pointed out that the managers have little incentive to worry about certain risks. His example went like this: Say there is a 1-in-50 chance of a company going out of business. If you are a 62-year-old executive planning on retiring at 65, it's not in your best interest to worry about it.
By contrast, the 77-year old Buffett and 84-year old Munger DO worry about risk. But they manage risk primarily by avoiding investments they don't understand. "Risk comes from not knowing what you're doing," Buffett once remarked.
And that, right there, is my answer to my friend of last night; that and the advice of Buffett's colleague Charlie Munger:
"We like businesses that drown in cash," Charlie Munger declared during the Berkshire Hathaway shareholder meeting in Omaha, Nebraska last weekend. Warren Buffet promptly agreed.
Throughout the meeting, Buffett and Munger repeatedly stressed the importance of investing in companies that provide ample cash flow or some other essential "margin of safety."
Sounds smart to me. You can read the whole report from the Munger and Buffet show here at Rude Awakenings. Just scroll down to How to "Drown in Cash" by Chris Mayer.