Warren Buffett on Risk: There Are Two Main Ways to Measure Risk

It is always important to remember that stock market volatility is not a measure of risk. Just because a stock goes up or down by 5%, it does not mean it is riskier than a stock going up by 2%.

According to Warren Buffett (Trades, Portfolio), there are two primary risks investors should seek to avoid at all costs. These are:

  1. The risk of a permanent capital impairment.

  2. The risk of inadequate return on capital.

Buffett's thoughts on risk

The Oracle of Omaha stated the above at the 2001 Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) annual meeting of shareholders. At the time, the dot-com bubble was starting to deflate. A number of audience members wanted to know if this had made the stock market significantly riskier than it has been in the past.

In his traditional no-nonsense style, Buffett explained that the market as a whole hadn't become a riskier proposition, but some stocks had. Using volatility as a measure of risk, he said, was nuts:

"We regard volatility as a measure of risk to be nuts. And the reason it's used is because the people that are teaching want to talk about risk. And the truth is, they don't know how to measure it in business. I mean, that would be part of our course on how to value a business. It would also be, how risky is the business? And we think about that in terms of every business we buy. And risk with us relates to -- Well, it relates to several possibilities. One is the risk of permanent capital loss. And then the other risk is just an inadequate return on the kind of capital we put in. It does not relate to volatility at all."

He went on to explain that risk also varies from business to business. Some companies don't generate a profit all year round, but this does not necessarily make them riskier. One example of this is Berkshire's See's Candy subsidiary:

"Our See's Candy business will lose money -- and it depends on when Easter falls -- but it'll lose money in two-quarters of the four quarters of the year. So it has a huge volatility of earnings within the year. It's one of the least risky businesses I know...

You can find all kinds of, you know, wonderful businesses that have great volatility and results. But it does not make them bad businesses. And you can find some very -- you can find some terrible businesses that are very smooth. I mean, you could have a business that did nothing, you know? And its results would not vary from quarter to quarter, right? So it just doesn't make any sense to translate volatility into risk."

Risk vs. volatility

This is something investors should pay attention to in the current environment. Just because a stock price is volatile does not necessarily mean that the business is riskier than any other company in the market.

Conversely, a stable stock price does not indicate low risk. Companies can and do frequently manipulate earnings and growth rates to appease analysts and investors and reduce the chances of stock price volatility. However, this does not necessarily mean that the stock is less risky. In fact, you could argue that risk increases when investing in these businesses because management is dishonest.

As is the case with so many subjects in investing, there's no one-size-fits-all template for evaluating risk in a stock. The best way to increase your chances of understanding the riskiness of an investment is to stick within your circle of competence and only invest in industries that you truly know and understand.

Disclosure: The author owns shares in Berkshire Hathaway.

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This article first appeared on GuruFocus.