1997: How do you define market risk?

AUDIENCE MEMBER: Maurus Spence from Omaha, Nebraska.

In light of recent stock market volatility, could you give us your definition of stock market risk, and how does your definition differ from the standard definition?

Finally, due to Charlie’s recent counter-revelation about jets, are you going to rename “The Indefensible?”

WARREN BUFFETT: Charlie would like to make an announcement on that second point. (Laughs)

CHARLIE MUNGER: Prompted by Al Ueltschi, we are changing the name of the company plane from “The Indefensible” to “The Indispensable.” (Laughter and applause)

WARREN BUFFETT: Yeah, it was Chateaubriand, who, incidentally, was a writer and philosopher in addition to being the father of a piece of meat — Chateaubriand wrote one time, I believe I’m correct on my attribution here, that events make more traitors than ideas.

And if you think about that in terms of Charlie’s remark, that the purchase of FlightSafety caused Charlie to have this counter-revelation. It’s an experience that is duplicated many times in life where people flip over very quickly to a new view based on their new circumstances.

Now, what was that first question again? (Laughter)

CHARLIE MUNGER: I might add that I have a friend who’s a United Airlines pilot, and he has recently been promoted into the 747-400. Before he started carrying people like you around for hire, he had to train intensively for five weeks. One-hundred percent of his training was in a simulator. They’re that good. So —

WARREN BUFFETT: They better be that good. They cost us about 19 million.

I mean, but they’re fabulous. I mean, if you think about — I think it’s 85 percent of the problems that you can encounter in a plane, if you attempted to teach people by actually being in a plane, they wouldn’t be here anymore, so there’s —

You want to develop the instincts and responses that can react to 85 percent of the problems, the only place to learn them is in a simulator, and probably the other 15 percent the best place is.

WARREN BUFFETT: Now, let’s go back to your first question. Give it to me again.

AUDIENCE MEMBER: The first part was, would you define — give us your definition of stock market risk and how it differs from the standard definition.

WARREN BUFFETT: Yeah. We don’t think in terms of — well, we think first in terms of business risk, you know.

We — the key to [Benjamin] Graham’s approach to investing is not thinking of stocks as stocks or part of a stock market. Stocks are part of a business. People in this room own a piece of a business. If the business does well, they’re going to do all right as long as they don’t pay way too much to join into that business.

So we look at — we’re thinking about business risk. Now, business risk can arise in various ways. It can arise from the capital structure when somebody sticks a ton of debt into some business, and so that if there’s a hiccup in the business that the lenders foreclose.

It can come about just by the nature of the — certain businesses are just very risky. Back in — when there were more commercial aircraft manufacturers, Charlie and I would think of making a commercial airplane, a big airliner, sort of as a bet-your-company risk because you would shove hundreds and hundreds of millions of dollars out into the pot before you really had customers.

And then if you had a problem with the plane, you know, that company could go. There’s certain businesses that inherently — because of long lead times, because of heavy capital investment — that basically have a lot of risk.

And commodity businesses have risk unless you’re the low-cost producer, because the low-cost producer can put you out of business.

Our textile business was not the low-cost producer. And we had a fine management, and everybody worked hard. We had cooperative unions, all kinds of things. But we weren’t the low-cost producer, so it was a risky business. The guy who could sell it cheaper than we could made it risky for us.

So there’s a lot of ways businesses can be risky.

We tend to go into businesses that inherently are low-risk, and are capitalized in a way that that low risk of the business is transformed into a low risk to the enterprise.

The risk beyond that is that even though you buy — identify — such businesses, that you pay too much for them. That risk is usually a risk of time rather than loss of principal, unless you get into a really extravagant situation.

But then the risk becomes the risk of you yourself. I mean, whether you can retain your belief in the real fundamentals of the business and not get too concerned about the stock market.

The stock market is there to serve you, and not to instruct you. And that’s a key to owning a good business, and getting rid of the risk that would otherwise exist in the market.

You mentioned volatility. It doesn’t make any difference to us whether the volatility of the stock market, you know, is — averages a half a percent a day or a quarter percent a day or 5 percent a day. In fact, we’d make a lot more money if volatility was higher, because it would create more mistakes in the market.

So volatility is a huge plus to the real investor.

Ben Graham used the example of “Mr. Market,” which is the — and we’ve used it. I’ve copied it in the report. I copy from all the good writers.

And Ben said, “You know, just imagine that when you buy a stock, that you — in effect, you’ve bought into a business where you have this obliging partner who comes around every day and offers you a price at which you’ll either buy or sell. And the price is identical.”

And no one ever gets that in a private business, where daily you get a buy-sell offer by a party. But in the stock market you get it. That’s a huge advantage. And it’s a bigger advantage if this partner of yours is a heavy-drinking manic depressive. (Laughter)

The crazier he is, the more money you’re going to make.

So you, as an investor, you love volatility. Not if you’re on margin, but if you’re an investor you aren’t on margin.

And if you’re an investor, you love the idea of wild swings because it means more things are going to get mispriced.

Actually, volatility in recent years has dampened from what it used to be. It looks bigger because people think in terms of Dow points and so they see these big numbers about plus 50 or minus 50 or something. But volatility was much higher many years ago than it is now. And you had — the amplitude of the swings was really wild. And that gave you more opportunity.

Charlie?

CHARLIE MUNGER: Well, it got to be the occasion in corporate finance departments of universities where they developed the notion of risk-adjusted returns. And my best advice to all of you would be to totally ignore this development.

Risk had a very good colloquial meaning, meaning a substantial chance that something would go horribly wrong. And the finance professors sort of got volatility mixed up with a lot of foolish mathematics.

To me, it’s less rational than what we do, and I don’t think we’re going to change. (Buffett laughs)

WARREN BUFFETT: Finance departments teach that volatility equals risk. Now, they want to measure risk, and they don’t know any other way. They don’t know how to do it, basically. And so they say that volatility measures risk.

And, you know, I’ve often used the example that the Washington Post stock when we first bought it had gone — in 1973 — had gone down almost 50 percent from a valuation of the whole company of close to, say, 180 or 175 million, down to maybe 80 million or 90 million.

And because it happened very fast, the beta of the stock had actually increased and a professor would have told you that the stock — company — was more risky if you bought it for 80 million than if you bought it for 170 million. Which is something that I’ve thought about ever since they told me that 25 years ago, and I still haven’t figured it out. (Laughter)