Buffett on Risk and Reward

One investor that Warren Buffett highlights in The Superinvestors of Graham-and-Doddsville, is Rick Guerin.

Buffett describes Guerin as "another non-business school type -- who was a math major at USC."

From the article:

"Rick, from 1965 to 1983, against a compounded gain of 316 percent for the S&P, came off with 22,200 percent, which probably because he lacks a business school education, he regards as statistically significant.

One sidelight here: it is extraordinary to me that the idea of buying dollar bills for 40 cents takes immediately to people or it doesn't take at all. It's like an inoculation. If it doesn't grab a person right away, I find that you can talk to him for years and show him records, and it doesn't make any difference. They just don't seem able to grasp the concept, simple as it is. A fellow like Rick Guerin, who had no formal education in business, understands immediately the value approach to investing and he's applying it five minutes later. I've never seen anyone who became a gradual convert over a ten-year period to this approach. It doesn't seem to be a matter of IQ or academic training. It's instant recognition, or it is nothing."

Then, later in the article, Warren Buffett said the following about risk and reward:

"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."

The idea that more risk is required to increase returns seems, at least for some, an article of faith. Yet, at least in the context of value-oriented investing, it need not be the case. The insight may be an extremely simple one but that doesn't make it any less significant. Not all useful insights or expertise require extreme complexity.*

It's a mistake to assume that risk and reward must be positively correlated.

Clearly, sometimes risk and reward is positively correlated; other times, it is not.

A useful and, yes, simple idea that's always been there for the taking (yet still seems to get little respect or attention).

If value is judged reasonably well, a lower price doesn't just increase the potential return -- all else equal -- it also can reduce risk.

Though, for some assets, no price is low enough (and no discount rate is high enough).**

No doubt some who've read Buffett's thinking on risk and reward find it to be of just passing interest. That's understandable but, I think, unfortunate.

I just happen to believe those who choose to not think about risk and reward this way are likely underestimating the benefits of doing so. Of course, that gets back to Buffett's comment above that it's usually "instant recognition, or it is nothing."

More risk being necessary for greater reward is more than just embedded in much of academia (CAPM being a good example), it also seems fairly well embedded in culture more generally.

Adam

Related posts:
-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
-Grantham on "The Greatest-Ever Failure of Economic Theory"
-Friends & Romans
-Superinvestors: Galileo vs The Flat Earth
-Max Planck: Resistance of the Human Mind

* Charlie Munger on why Berkshire's model isn't copied more: "...our model is too simple. Most people believe you can't be an expert if it's too simple."
** Warren Buffett once said the following about discount rates:"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. We don't discount the future cash flows at 9% or 10%; we use the U.S. Treasury rate. We try to deal with things about which we are quite certain. You can't compensate for risk by using a high discount rate."
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