Wednesday, March 4, 2015

Stocks and Risk

From Warren Buffett's most recent Berkshire Hathaway (BRKa) shareholder letter:*

"The unconventional, but inescapable, conclusion to be drawn from the past fifty years is that it has been far safer to invest in a diversified collection of American businesses than to invest in securities – Treasuries, for example – whose values have been tied to American currency. That was also true in the preceding half-century, a period including the Great Depression and two world wars. Investors should heed this history. To one degree or another it is almost certain to be repeated during the next century.

Stock prices will always be far more
volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.

It is true, of course, that owning equities for a day or a week or a year is far riskier (in both nominal and purchasing-power terms) than leaving funds in cash equivalents. That is relevant to certain investors – say, investment banks – whose viability can be threatened by declines in asset prices and which might be forced to sell securities during depressed markets. Additionally, any party that might have meaningful near-term needs for funds should keep appropriate sums in Treasuries or insured bank deposits.

For the great majority of investors, however, who can – and
should – invest with a multi-decade horizon, quotational declines are unimportant. Their focus should remain fixed on attaining significant gains in purchasing power over their investing lifetime. For them, a diversified equity portfolio, bought over time, will prove far less risky than dollar-based securities."

This isn't simply a minor disagreement with modern finance theory. It's a major one. Modern theory considers the idea that stocks return more than other assets because they are more risky as some kind of fundamental truism.

Warren Buffett is saying that the exact opposite, in some circumstances, can be true in the long run. Consider this the next time someone says more risk must be taken to achieve greater returns and assumes there's always a positive correlation.

More risk = more rewards?

Not exactly.

The whole idea sounds reasonable enough but, well, it's flawed at best.

In fact, the real world provides us something a far more challenging when it comes time to understand risk and its relationship with investment returns.

Howard Marks offered this take in a memo last year:

Howard Marks on Risk

"We hear it all the time: 'Riskier investments produce higher returns' and 'If you want to make more money, take more risk.'

Both of these formulations are terrible. In brief, if riskier investments could be counted on to produce higher returns, they wouldn't be riskier."

A chart on page 6 of the memo by Marks presents risk and return the traditional way (with risk and return positively correlated). A second chart on the same page explains the relationship between risk and reward in a way that, to me, much more closely represents the world as it is. As far as I'm concerned it's a much more useful and correct depiction of risk and return.

How often do investors, whether it's explicit or not, assume incremental risk is required to generate incremental returns?

This assumption is a rather costly one for too many market participants. Near-term volatility -- as measured by beta -- just isn't very likely to reveal much about the long-term risks and potential returns of an investment (despite what finance theory suggests).** It'd be nice if understanding long-term investment risk came down to a single number. Unfortunately, making judgments about risk is necessarily imprecise and tough to quantify.

Those who choose to invest based upon some torched version of reality aren't likely to produce satisfactory investment outcomes.

Contending with all the illusions, biases, and fallacies -- among other things -- already makes investing well tough enough to do consistently well. So, wherever possible, it's essential to eliminate any distraction that might be caused by plainly flawed models.

Cash for near-term needs is essential. Funds needed in the next few years (and maybe even somewhat longer) should never be in stocks. Yet cash also has the lowest possible volatility -- so theory says it shouldn't be risky -- but the long-term risk ends up being not at all small.

A diversified basket of stocks bought with funds needed in the near-term and even intermediate-term is, of course, much riskier than cash.

Sometimes risk and reward must correlate in a positive manner.

It just need not necessarily be the case with a long enough time horizon.

Owning a portfolio of fine businesses long-term -- the only appropriate time horizon for equities -- allows risk to become much reduced.

Fortunately, many convenient low cost ways exist to obtain partial ownership of a diversified basket of businesses.

Whether mutual funds (incl. ETFs) or individual stocks is the right way to go naturally depends on the investor.


Long position in BRKb established at much lower than recent market prices

Related posts:
-Quality Stocks & the Risk-Return Tradeoff
-Howard Marks on Risk
-Grantham on Efficient Markets, Bubbles, and Ignoble Prizes
-Efficient Markets - Part II
-Risk and Reward Revisited
-Efficient Markets
-Modern Portfolio Theory, Efficient Markets, and the Flat Earth Revisited
-Buffett on Risk and Reward
-Buffett: Why Stocks Beat Bonds
-Beta, Risk, & the Inconvenient Real World Special Case
-Howard Marks: The Two Main Risks in the Investment World
-Black-Scholes and the Flat Earth Society
-Buffett: Indebted to Academics
-Friends & Romans
-Superinvestors: Galileo vs The Flat Earth
-Max Planck: Resistance of the Human Mind

* See page 18.
** According to the capital asset pricing model (CAPM), for example, highly volatile stocks should produce higher returns than the less volatile stocks to compensate investors for the additional risk. CAPM is a one factor model. In this model beta is the measure of volatility and is supposed to (somehow) represent risk. Well, the estimation of risk is necessarily qualitative and can't be captured by a single factor like beta. The Fama and French three factor model adds two additional factors. Others might find this stuff useful. I find none of it to be. Pure distraction.
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