The Lesson Warren Buffett Says Hasn’t Been Taught in Business School

Risk and Volatility | Lesson from Warren Buffett | Sheaff Brock

The Lesson Warren Buffett Says Hasn’t Been Taught in Business School

“Risk is not the same as volatility, but that lesson has not customarily been taught in business schools,” Warren Buffett observes. “Volatility is far from synonymous with risk.” In a 2015 letter to shareholders, the Berkshire Hathaway CEO wrote about the difference between risk and volatility. Many investors, he observes, “conflate these concepts, costing themselves money.”

Yes, stock prices will always be far more volatile than cash-equivalents, Buffett concedes, but over the long term, currency-denominated instruments are far riskier than widely diversified stock portfolios. Yet that lesson, he points out, has not customarily been taught in business schools, “where volatility is almost universally used as a proxy for risk.”

Market volatility can be seen through the VIX or Volatility Index, created by the Chicago Board of Options Exchange. The VIX gauges “bets” investors and traders are making on either the general direction of the markets or on individual securities. A high reading on the VIX implies a risky market, Investopedia explains.

So what IS the lesson about volatility and risk that deserves to be taught, according to Warren Buffett? “It is important to remember that the stock market does not exist to instruct investors; it is there to serve them,” Buffett teaches. “Put another way: Market volatility is a bad measure of investor risk.”

In a 2018 interview with CNBC, Buffett took the concept even further: “Volatility is a huge plus to real investors.”

So what about investment risk, then? There may be volatility, but you don’t run any real risk, Buffett says, assuming you:

  • Understand the economics of the business in which you’re engaged
  • Know the people with whom you’re doing business
  • Know the price you’re paying for the investment is sensible

Sheaff Brock Director Jim Murphy agrees that understanding the difference between market volatility and market risk is a key skill for investors to have. Key to that understanding is realizing that while volatility demonstrates how rapidly or severely the price of an investment may change, risk describes the possibility that an investment will result in permanent loss of capital.

The message to investors: It’s a tragic, although classic, mistake to learn the “wrong lesson” from the market. You can put yourself at a disadvantage by equating risk and volatility rather than adopting strategies that might potentially profit from volatility.

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