2004: How does Buffett think about high magnitude but low frequency events?

AUDIENCE MEMBER: John Bailey from Boston.

As of last week, my house is almost totally covered with Benjamin Moore now. (Laughter)

But more seriously, you spent a fair amount of time talking about the low-probability transformative events. I recall a discussion on the probability of a nuclear event not occurring in any given year for, say, 50 years, at which point it begins to look like, over the time period, it’s pretty darn likely and therefore the expected value is a pretty big negative.

There are some other things that could be happening that somebody might expect. For instance, perhaps there is, in fact, a ceiling on consumer debt coverage ratios. If they quit falling, there — that could be a big change.

If you even listen to the United States Geological Survey, they’re now saying that sometime in the next 50 years, there could be a fall in the production of oil.

And so, I’d like you to address how you conceive of the portfolio of businesses in the context of these possible transformative events, especially given that over this same time period of maybe the next 50 years, at some point, you’re not going to be able to personally revise the portfolio.

WARREN BUFFETT: Yeah, I think it’s a fair statement that over the next 50 years at some point, Charlie and I will not personally be able to — (laughs) — participate in portfolio revisions. The —

Well, you’re quite correct that people tend to underestimate low-probability events when they haven’t happened recently and overestimate them when they have happened recently.

That is the nature of the human animal. You know, Noah ran into that some years back. But he looked pretty good after 40 days. The —

What you mention on the nuclear question, it’s a matter — you can do the math easily. What you don’t know is whether you’re using the right assumptions. But it —

For example, if there is a 10 percent chance in any given year of a major nuclear event, the chance that you’ll get through 50 years without it happening, if the 10 percent is correct, is a half of 1 percent.

I mean, 99 1/2 percent of the time a 10 percent event per year will catch up with you in 50 years. If you can reduce that to 1 percent, there’s a 60 percent chance you get through the next 50 years without it happening.

That’s a good argument for trying to reduce the chances of it happening.

In terms of our businesses, I think Charlie and I are — I mean, we think about low-probability events. In fact, in insurance, we probably think about low-probability events more than most people who have been insurance executives throughout their years. It’s just our nature to think about that sort of thing.

But I would say, if you talk about transforming events, or really talk about major events that could have huge consequences that are low probability, they’re more likely to be in the financial arena than in the natural phenomena arena. But we’ll think about them in both cases.

But we do spend a lot of time thinking about things that can go wrong in a very big and very unexpected way.

And financial markets are — they have vulnerabilities to that, you know, we try to think of and we try to build in ways to protect us against it and perhaps even build in some capabilities where we think we might profit in a huge way from it.

Charlie?

CHARLIE MUNGER: Yeah, that temporary collapse in the junk bonds, where they got down, many of them, to 35 and 40 percent yields, that’s a strange thing. And to have all those things pop back — you know, quadrupling in a short time. There was absolute chaos at the bottom tick of that.

And that isn’t as much chaos as you could have. And of course, it can happen in common stocks instead of junk bonds.

So I think if you’re talking about the next 50 years, we all have to conduct ourselves so that we — it won’t be all that awful if a real financial crunch of some kind could come along. Either inflationary or a typical deflationary crunch of the time [kind] that people used to have a great many decades ago.

WARREN BUFFETT: Probably the most dramatic way in which we are — give evidence of our — of your worries, is we just don’t believe in a lot of leverage. I mean, you could have thought junk bonds were wonderful at 15 percent because they eventually did go to 6 percent, you would have made a lot of money.

But if you owed a lot of money against them in between, you know, you wouldn’t have been around for the party at the end.

So we believe almost anything can happen in financial markets. And the only way smart people can get clobbered, really, is through leverage. If you can hold them, you have no real problems.

So we have a great aversion to leverage and we would predict that a very high percentage of the smart people operating in Wall Street, at one time or another, are likely to get clobbered through the use of leverage.

It’s the one thing that forces you — it’s the one thing that ends — or can prevent you from playing out your hand. And all of the hands we enter into look pretty good to us. But you do have to be able to play them out.

And the fascinating thing to me is that — just take the junk bond situation. In 2002, you had people with terrific IQ — tens of thousands of them operating in Wall Street. You had the — money was available. They all had a desire to make money.

And then you see these extraordinary things happen in markets and you say to yourself, you know, can these be the same individuals that two years later or two years earlier were buying these things at prices that were double or triple or quadruple what they sunk to in between? And did they all go on vacation? You know, did they lose their ability to raise money?

No, the money was — you know, Wall Street was awash in money, and it was awash in talent, and yet you get these absolutely extraordinary swings.

I mean, it doesn’t happen with apartment houses in Omaha or, you know, with McDonald’s franchises or farms or something. But it’s just astounding what can happen in the marketable securities department.

And the big thing you want to do is, at a minimum, you want to protect yourself against that sort of insanity wiping you out.

And better yet, you want to be prepared to take advantage of it when I happens.

Now it’s about noon, so we will come back and begin at microphone 2 about, say, a quarter of one.