“This great emphasis on volatility in corporate finance we regard as nonsense. Let me put it this way; as long as the odds are in our favor and we’re not risking the whole company on one throw of the dice or anything close to it, we don’t mind volatility in results. What we want are favorable odds.” — Charlie Munger
This week our featured book is Charlie Munger: The Complete Investor, by Tren Griffin. For our final two posts, we are happy to present a post from Tren Griffin explaining Charlie Munger’s take on the importance of understanding and being aware of risk in investing. The post was originally featured on Griffin’s blog, 25iq.
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A Dozen Things I’ve Learned from Charlie Munger About Risk, Part 1
By Tren Griffin
“Risk to us is 1) the risk of permanent loss of capital, or 2) the risk of inadequate return.”
Risk has many different dimensions that must be considered including sources, magnitude, outcomes and decision making inputs. In terms of a definition, Seth Klarman writes that risk is: “described by both the probability and the potential amount of loss.” Charlie Munger emphasizes an important point in his quotation since it is the permanent loss which should be the focus of investors since temporary drops can actually represent an opportunity for an investor if they can purchase more of an asset at the lower price and ride out the drop in price. The focus of this definition of risk is on potential “outcomes.” In terms of “sources” of risk, Warren Buffett believes that “risk comes from not knowing what you’re doing” and that “the best way to minimize risk is to think.” This is why Charlie Munger spends so much time thinking about thinking. The magnitude of risk assumed by a given investor on any investment depends on the nature of the asset, but also the price paid for the asset. In addition to not knowing what you are doing, one way to increase risk to pay such a high price for an asset that there is no margin for error. Seth Klarman makes the important point that “risk and return must be assessed independently or every investment…. risk does not create incremental return only price can do that.” Howard Marks makes the insightful point that risk itself cannot be counted on to generate higher financial returns, since if this was the case the assets would not actually be riskier. Richard Zeckhauser has his own definition of risk focused on the “inputs” a person has in the decision-making process rather that the “outcome” based definition of Buffett and Klarman. Zeckhauser believes that “risk” is limited to situations where all potential future states and their probabilities are known. Roulette in his view involves risk since you know all future states and probabilities in playing the game. When the probabilities of potential future states are not known, Zeckhauser calls that situation “uncertainty” and when you don’t know all potential future states he refers to that as “ignorance.” Most of life is uncertain rather than risky. True risk, as Zeckhauser defines it, is actually not that common in real life. For the rest of this blog post when I refer to “risk” I will be referring to the Klarman/Buffett/Marks definition of risk as an outcome (‘the possibility of loss or injury”) because that is what I believe Charlie Munger is referring to in each quotation.
“Using [a stock’s] volatility as a measure of risk is nuts.”
There is a yet another way that some people talk about risk. Howard Marks writes: “Volatility is the academic’s choice for defining and measuring risk. I think this is the case largely because volatility is quantifiable and thus usable in calculations and models of modern finance theory….However, while volatility is quantifiable and machinable – and can be an indicator or symptom of riskiness and even a specific form of risk – I think it falls far short as “the” definition of investment risk. In thinking about risk, we want to identify the thing that investors worry about and thus demand compensation for bearing. I don’t think most investors fear volatility. In fact, I’ve never heard anyone say, ‘The prospective return isn’t high enough to warrant bearing all that volatility.’ What they fear is the possibility of permanent loss.” Munger rejects the use of volatility to define risk. He describes part of the reason for the desire of some people to qualify risk as follows: “Practically everybody (1) overweighs the stuff that can be numbered, because it yields to the statistical techniques they’re taught in academia, and (2) doesn’t mix in the hard-to-measure stuff that may be more important. That is a mistake I’ve tried all my life to avoid, and I have no regrets for having done that.” Munger has also said: “Beta and modern portfolio theory and the like — none of it makes any sense to me. We’re trying to buy businesses with sustainable competitive advantages at a low, or even a fair, price.” Why do some people want so badly to equate risk with volatility? This assumption allows them to create beautiful mathematical models that can be included in their papers. Seth Klarman describes the motivation for this line of thinking in his book: “A positive correlation between risk and return would hold consistently only in an efficient market.” To be able to create this beautiful math Munger believes they distort the world to be fully rational to support their mathematical theories even though it defies common sense. This attempt to equate risk and volatility is a classic case of confirmation bias. Munger says: “I have a name for people who went to the extreme efficient market theory—which is ‘bonkers.’ It was an intellectually consistent theory that enabled them to do pretty mathematics. So I understand its seductiveness to people with large mathematical gifts. It just had a difficulty in that the fundamental assumption did not tie properly to reality.” Risk is not a number and it certainly can’t be calculated simply based on volatility. Volatility can be “a” risk for some people in some situations, but it certainly does not “define” risk. As an analogy, an apple is fruit but apples do not define fruit. There is certainly a time element to risk and life events like retirement or a college bill can turn volatility into an important type of risk, especially over shorter time frames. But value investors are usually focused on long-term returns and understand that they may be able to earn a premium by accepting short-term volatility when buying an asset. As an example, short term US Treasuries may have lower short-term volatility but they have significant long-term risk of underperformance in comparison to equities. Seth Klarman writes: “some insist that risk and return are always positively correlated…yet this is not always true. Others mistakenly equate risk with volatility, ignoring the risk of making overpriced, ill-conceived and poorly managed investments.” Volatility is actually the friend of the investor since lower prices are what create opportunities to buy mispriced assets at a significant discount to intrinsic value.
“Volatility is an overworked concept. You shouldn’t be imprisoned by volatility.” “Some great businesses have very volatile returns – for example, See’s usually loses money in two quarters of each year – and some terrible businesses can have steady results.”
Charlie Munger and Warren Buffett are very focused on finding investments which possess odds of success that are substantially in their favor. If the process of generating returns along the way is lumpy that is not only perfectly acceptable but it can be a significant financial advantage since others may be unwilling to do so creating mispriced assets that can be purchased at a bargain price. Howard Marks argues: “in order to achieve superior results, an investor must be able – with some regularity – to find asymmetries: instances when the upside potential exceeds the downside risk. That’s what successful investing is all about.” A regular reader of this blog will recognize what Howard Marks is taking about as an objective as positive optionality (big upside and a small downside).
“We don’t give a damn about lumpy results. Everyone else is trying to please Wall Street. This is not a small advantage.”
Munger is pointing out that buying what is unpopular or requires a long term viewpoint tends to be underpriced. Since buying underpriced assets creates a margin of safety, it lowers risk and increases financial returns. On volatility, Ben Graham once wrote: “A serious investor is not likely to believe that the day-to-day or month-to-month fluctuations of the stock market make him richer or poorer…. The holder of marketable securities actually has a double status, and with it the privilege of taking advantage of either at his choice. On the one hand his position is analogous to that of a minority shareholder or silent partner in a private business. Here his results are entirely dependent on the profits of the enterprise or a change in the underlying value of its assets. He would usually determine the value of such a private-business interest by calculating his share of the net worth as shown in the most recent balance sheet. On the other hand, the common-stock investor holds a piece of paper, an engraved stock certificate, which can be sold in a matter of minutes at a price which varies from moment to moment – when the market is open, that is — and often is far removed from the balance sheet value.” One reason why volatility is such a big focus for managers, as opposed to investors, is that it presents a big risk for them. Investors tend to flee an advisor or fund when there is underperformance or drop in price.
“This great emphasis on volatility in corporate finance we regard as nonsense. Let me put it this way; as long as the odds are in our favor and we’re not risking the whole company on one throw of the dice or anything close to it, we don’t mind volatility in results. What we want are favorable odds.”
Charlie Munger has said that he is a “focus” investor since he is not a “know nothing” investor. In his personal accounts and fund he manages he is not a believer in diversification. He is also careful to note that few people should invest like him and should instead buy a diversified portfolio of low cost index funds. Warren Buffett’s statement about what he and Charlie Munger do at Berkshire is as famous as it is succinct. “Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we’re trying to do. It’s imperfect, but that’s what it’s all about.” For Howard Marks, risk is “the possibility of permanent loss… downward fluctuation which by definition is temporary doesn’t present a big problem if the investor is able to hold on and come out the other side.” The same idea applies to a manager in a business investing capital. Some opportunities require that you be willing to have volatile earnings. See’s Candies is just such an example. Since profits happen in the box candy business mostly during the holidays See’s will inevitably have poor financial results half the year but that will be offset by two very profitable quarters.
“All investment evaluations should begin by measuring risk, especially reputational. This is said to involve incorporating an appropriate margin of safety, avoiding permanent loss of capital and insisting on proper compensation for risk assumed.”
If you decide to incur risk and face the possibility of loss or injury, you should insist on being paid for doing so. Munger is saying that the best way to manage investment risk is to buy assets at a price that reflects enough of a margin of safety that the outcome will be favorable even if you make a mistake (i.e., buy with a margin of safety- which is a discount to expected value). This is why Howard Marks says that risk is always relative to the amount paid for the asset. Buffett wrote in his postscript to The Intelligent Investor (2003 edition) about the way value investors should view risk: “Sometimes risk and reward are correlated in a positive fashion… the exact opposite is true in value investing. If you buy a dollar for 60 cents, it is riskier than if you buy a dollar for 40 cents, but the expectation for reward is greater in the latter case.”