This my ninth article on the nuanced concepts of investment risk for life insurance salespersons. You can read all my previous articles and more in my Blog https://www.helpindiainsure.iistpune.in/category/finance-for-life-insurance/. Life insurance salespersons will sell ethically and correctly, if the concepts of investment risks are understood. Each of the articles so far and the subsequent ones to follow will explore the concept of investment risk in all its nuances.
Warren Buffet, considered as the most successful investor in history, is retiring from active professional life this year end. There are important lessons to be learnt from Buffet’s approach to risk management. Here is a short and summarized note on Buffet’s risk management strategies.
Risk according to Buffet
For Buffet, it is not the markets that create investment risk. Share price volatility is not the risk in investments. As he says, risk comes from not knowing what you are doing. This is quite different from the definition that risk can be measured by price volatility, as practiced by the proponents of Modern Portfolio Theory.
Investment managers following the principles of Modern Portfolio Theory take β (pronounced be-ta) as the measure of risk. β calculates risk as the volatility of the share price of a stock relative to the market as a whole. A beta coefficient greater than 1 shows that the share is risky. The higher the beta coefficient above 1, the more the risk. Very neat calculation. But the beta does not tell us anything about the company or the risks of investing in that company.
Buffet in principle never made such calculations. For him, risk comes from not knowing what you are doing.
This is a fundamental shift in understanding risk. Essentially, the shift in the thought process on risk means that the investor should know as much about the markets, the company and the industry as possible. Depending on a single coefficient such as β, avoids an in-depth analysis of risk. β is the result of risk, it does not tell you what the risks are.
Long-term not short-term
Warren Buffet belongs to the school of value investing. Value investing is the school of thought of Benjamin Graham[i]. Warren Buffet learnt Value Investing from Benjamin Graham.
Value Investing: Value investing is an investment strategy where you research stocks and companies and choose only those companies with sound financials and whose share price is lower than the intrinsic worth of the company. Once a company is chosen by this method, you stay invested in the company for the long run.
This was Buffet’s strategy. It was central to his choice of stocks and companies to invest in. Once invested, Buffet kept the stock for the long term. Following such an approach requires the would-be investor would be required to put in considerable time. Most investors prefer to take one or two indicators or depend on an advisor for advice. Or invest based on emotions or biases.
Misleading take on value investing: Taking a cue from Buffet’s strategy, many investment managers and advisors advise investors to stay invested for the long term. The long-term concept is misused in most investment advisories. Buffet’s long-term strategy was based on considerable research. It does not mean that you pick any stock or mutual fund and simply forget about it for a few decades.
Most stocks and mutual funds available in the market do not give adequate returns. One must form an informed judgement to invest.
The most important risk-mitigation strategy of Buffet was therefore to choose companies that worked for long-term goals rather than for short-term goals.
Not stock pickers
Linked to the long-term strategy.
As Buffet mentions in his 2022 Letter to Shareholders, ‘Charlie and I are not stock-pickers; we are business-pickers’.
It will be useful to understand the statement above. A stock picker is one who buys and sells shares frequently. Most mutual fund managers do this. A share is bought in the hope that the price of that share will rise in the short run, giving the investor a quick profit.
This according to Buffet is a very risky method of investing. Since share prices cannot be predicted with any degree of accuracy, stock picking is a blind man’s game. Buffet believes that investment risk is lower if one studies businesses and remain invested for the long run.
No exit policy
Also linked to the long-term holding strategy, Buffet did not believe that one should sell when the price of the share is high. In his 2005 Letter to Shareholders, he mentions that unlike many business buyers, Berkshire (Warren Buffet’s company) has no exit strategy.
The logic of ‘No exit policy’ can best be given by an example. Suppose you buy a stock for Rs. 100 and the price moves up to Rs. 120 in about a year’s time. An investor may be tempted to sell and make good his gains. Buffet’s view is if you have picked the business to invest in knowledgably and meeting all your criteria of a good investment, in the long run the share price is more likely to rise considerably. By selling you are missing out on that future value.
The argument that the markets may crash, according to Buffet, is no reason to sell your market holdings. Markets crash and rise again in a cyclical movement. As long as the company you have invested in is financially sound with a good management team at the top, the share price will continue to grow.
Berkshire, however, does have an Entrance Strategy. Buffet searches for businesses that meet their criteria and are available at a price that will produce a reasonable return. This part is crucial if you are to stay invested in a company for the long-term.
Diversification does not necessarily reduce risk
Modern Portfolio Theory is based on the principle that diversification of investments reduces risk. As the proponents of Modern Portfolio Theory put it: do not put all your eggs in one basket.
Buffet says not necessarily. In his words, ‘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’.[ii]
Shun Debt
Buffet would typically look for companies with a low debt, preferably not more than a 2:1 debt equity ratio. The more the debt the higher the chances of failure of that company, making the investment risky. Even in his own company, Berkshire, Buffet follows the same policy.
Build reserves
A strong feature of Buffet’s risk management was to build up the reserves of Berkshire as much as possible. Market and other risks that Berkshire faced needed a kind of shock absorber. Building a high net worth is Buffet’s method. Buffet mentions in his 2005 Letter to Shareholders that whether there are financial panics in the share markets, or there are stock exchange closures or even nuclear/chemical/biological attacks, Berkshire has the net worth, the liquidity and earning streams to handle the risks.
Holding cash is not seen as a dead investment
In his 2021 Letter to the Shareholders, he mentions that Berkshire had $ 144 billion in cash or cash equivalent, including $ 120 billion in US Treasury Bills. This represents roughly one-fourth of Berkshire’s investment portfolio. Holding cash is seen as a risk management strategy. Buffet was very successful using this strategy. The company faced many market crashes over decades of investing. But Buffet’s investments only grew in value, making Buffet one of the richest persons in the world.
This is only a short and brief explanation of Buffet’s strategy and approach to risk management. A deeper study will undoubtedly reveal much more about the legendary investor. Would anybody like to contribute to explain Buffet’s approach to risk management? Please write in the comments below.
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More insights in my next article. Look out for regular articles on the concept of risk. In the meanwhile, you may also visit the website (https://www.iistpune.in/) of The Institute of Insurance Sales Training (IIST) to know more about the number of ways we can help you reach great heights in life insurance sales team building and selling.
[i] Benjamin Graham, 2020, The Intelligent Investor, HarprCollins Publishers Inc., Revised edition with commentary and notes by Jason Zweig
[ii] Source: https://www.vintagevalueinvesting.com/how-warren-buffett-thinks-about-risk/ Vintage Value Investing, How Warren Buffett Thinks About Risk Dillon (Mr. Vintage Value Investing, March 9, 2016