Portfolio Managers • Advisers • Financial Planners











As Warren Buffet stated in Berkshire Hathaway's 1993 letter to shareholders, “Academics, however, like to define investment 'risk' differently, averring that it is the relative volatility of a stock or portfolio of stocks - that is, their volatility as compared to that of a large universe of stocks. Employing data bases and statistical skills, these academics compute with precision the 'beta' of a stock - its relative volatility in the past - and then build arcane investment and capital-allocation theories around this calculation. In their hunger for a single statistic to measure risk, however, they forget a fundamental principle: It is better to be approximately right than precisely wrong.

For owners of a business - and that's the way we think of shareholders - the academics' definition of risk is far off the mark, so much so that it produces absurdities. For example, under beta-based theory, a stock that has dropped very sharply compared to the market - as had Washington Post when we bought it in 1973 - becomes 'riskier' at the lower price than it was at the higher price. Would that description have then made any sense to someone who was offered the entire company at a vastly-reduced price? In fact, the true investor welcomes volatility. Ben Graham explained why in Chapter 8 of The Intelligent Investor. There he introduced 'Mr. Market'.

In assessing risk, a beta purist will disdain examining what a company produces, what its competitors are doing, or how much borrowed money the business employs. He may even prefer not to know the company's name. What he treasures is the price history of its stock. In contrast, we'll happily forgo knowing the price history and instead will seek whatever information will further our understanding of the company's business. After we buy a stock, consequently, we would not be disturbed if markets closed for a year or two. We don't need a daily quote on our 100% position in See's or H. H. Brown to validate our well-being. Why, then, should we need a quote on our 7% interest in Coke?

In our opinion, the real risk that an investor must assess is whether his aggregate after-tax receipts from an investment (including those he receives on sale) will, over his prospective holding period, give him at least as much purchasing power as he had to begin with, plus a modest rate of interest on that initial stake. Though this risk cannot be calculated with engineering precision, it can in some cases be judged with a degree of accuracy that is useful.

The primary factors bearing upon this evaluation are:

  1. The certainty with which the long-term economic characteristics of the business can be evaluated;
  2. The certainty with which management can be evaluated, both as to its ability to realize the full potential of the business and to wisely employ its cash flows;
  3. The certainty with which management can be counted on to channel the rewards from the business to the shareholders rather than to itself;
  4. The purchase price of the business;
  5. The levels of taxation and inflation that will be experienced and that will determine the degree by which an investor's purchasing-power return is reduced from his gross return.


These factors will probably strike many analysts as unbearably fuzzy, since they cannot be extracted from a data base of any kind.

But the difficulty of precisely quantifying these matters does not negate their importance nor is it insuperable. Just as Justice Stewart found it impossible to formulate a test for obscenity but nevertheless asserted, 'I know it when I see it,' so also can investors - in an inexact but useful way – 'see' the risks inherent in certain investments without reference to complex equations or price histories.” 1

Risk is purely a function of what is lost (price) and what is gained (value). If an investment can be acquired at a price significantly less than its value, risk is low. Hence, risk is primarily a function of valuation, determined through fundamental analysis.

© Daniel Dower (2011)








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