What Warren Buffett Can Teach Us About Risk

We’re turning our blog over to a guest blogger today. Vincent Linsley is a Canadian investment management sales and marketing professional. He also authors a blog, Investment Graffiti.

 

Warren Buffett’s 2019 Annual Letter to Shareholders was delivered on February 23 and eagerly-read by investors worldwide. The much-anticipated update provided an inside look at his company, currently the world’s highest-priced stock, trading at over US$300,000 per share.

The epitome of “basic” no frills writing style and structure, Buffett’s disciples read the letter religiously, looking for his expert perspectives on the market and always quotable market musings.

This year’s letter revealed a number of key takeaways:

  • Buffett has still not made any of the “elephant-sized” acquisitions he has been on the lookout for, as he feels prices are too high
  • Buffett is focusing on purchasing equities but doesn’t make a call on the market or explicitly state stock prices are particularly attractive
  • Buffett continues to hold a large cash position ($112B), awaiting opportunities to deploy
  • He believes in the US economy and that it will be resilient to any short-term challenges

The fourth quarter was a tough one as the market corrected and there were issues with one of his larger holdings. Overall, in 2018, the company delivered a modest 2.8% return, beating the S&P 500 by 6%.

There were some who questioned why Buffett didn’t double down on the market dip in December and once again, he explained his thoughts on using debt to “juice” returns.

“Rational people don’t risk what they have and need for what they don’t have and don’t need.”

He was asked a similar question in 2018, when individuals wondered how much more he “could” have made, particularly in this bull market by using leverage to amplify his returns. His response was the same.

In his opinion, these are not good bets. He needn’t apologize — he has doubled the market average since the company was launched, delivering approximately 20% annually.

But still, there are those who question what additional gains he is leaving on the table. In 2017, FANG stocks delivered high double-digit returns, marijuana stocks were doubling and tripling in value and Bitcoin jumped about 20x its value from the start of the year.

These skeptical comments are reminiscent of a popular expression used frequently within social media; FOMO, or the fear of missing out.

FOMO is defined as “an omnipresent anxiety brought on by our cognitive ability to recognize potential opportunities.” It is usually associated with exciting social media posts and the need for individuals to continually check what experiences others are having.

FOMO doesn’t just impact social media, however. It impacts investors as well.

In a bull market, the temptation to take on additional risk can be overwhelming and FOMO can easily set in.

The stock market has been on a 10-year bull run since the 2008 credit crisis, which has been great news for investors. And while no one is complaining, everyone’s expectations on what constitutes a “normal” return are now skewed much higher.

The media perpetuates this impression by highlighting returns in hot sectors. Not being part of these trends and simply earning a decent “average” return can become completely unsatisfying. In behavioural finance, the tendency for risk tolerances to change with the market, leading to overconfidence when things are going well is referred to as “frame dependence.”

The good news for investors is that Warren Buffett doesn’t experience FOMO.

If Warren Buffett needed to be part of the crowd, he would have strayed from his high conviction philosophy and would have looked at acquiring trending stocks to carry his net worth even higher. But he doesn’t do that.

Buffett’s key qualities for acquiring businesses are “durable competitive strengths; able and high-grade management; good returns on the net tangible assets required to operate the business; opportunities for internal growth at attractive returns; and, finally, a sensible purchase price.”

It’s the last one that makes it the most difficult for him to add new companies to his list. Instead, he sticks by his mantra, “the less the prudence with which others conduct their affairs, the greater the prudence with which we must conduct our own.”

He doesn’t buy companies if the valuations don’t make sense, even if others are. Buying based on fads and trending share prices brings in volatility and unpredictability.

Managing risk in your portfolio today is critical to your success and ensures that your objectives, i.e. the reason you are investing, stay intact. In this environment, the temptation to deviate outside of our risk tolerance is high, but Warren Buffett reminds everyone that taking on unnecessary risk is not necessarily worth the reward, particularly if it places your capital and your investment goals in jeopardy.

2019 has started off as one of the best for the market in 32 years. While there continues to be a lot of positive indicators, there are some experts predicting that we shouldn’t be surprised if we see a pullback or even a recession on the horizon.

There is a saying that smart investors don’t trade to maximize expected value; they trade to minimize regret. Buffett is a master of this and his track record demonstrate its success.

Warren Buffett’s quote reminds us of the importance of risk and to manage it appropriately regardless of which stage the market is at.

More importantly, our focus should be on remembering our investment objectives and not risking them for what we don’t need.

To see the full copy of Warren Buffett’s 2019 Shareholder Letter, click here.

 

Alan Friedman is an Investment Advisor with CIBC Wood Gundy in Toronto. The views of Alan Friedman do not necessarily reflect those of CIBC World Markets Inc. CIBC Wood Gundy is a division of CIBC World Markets Inc. a subsidiary of CIBC and a Member of the Canadian Investor Protection Fund and Investment Industry Regulatory Organization of Canada. If you are currently a CIBC Wood Gundy client, please contact your Investment Advisor.

 

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