STREET DOGS

From “The Super investors of Graham-and Doddsville” by Warren E Buffett, published in the Fall 1984 issue of Hermes, Columbia Business School magazine.

I would like to say one important thing about risk and reward. Sometimes risk and reward are correlated in a positive fashion. If someone were to say to me: “I have here a six-shooter and I have slipped one cartridge into it. Why don’t you just spin it and pull the trigger once? If you survive, I will give you $1m.” I would decline – perhaps stating that $1m is not enough. Then he might offer me $5m to pull the trigger twice — now that would be a positive correlation between risk and reward.

The exact opposite is true with value investing. If you buy a dollar bill for 60c, it’s riskier than if you buy a dollar bill for 40c, but the expectation of reward is greater in the latter case.

The greater the potential for reward in the value portfolio, the less risk there is.

One quick example: The Washington Post Company in 1973 was selling for $80m in the market. At the time, that day, you could have sold the assets to any one of 10 buyers for not less than $400m, probably appreciably more. The company owned the Post, Newsweek, plus several television stations in major markets. Those same properties are worth $2bn now …

Now, if the stock had declined even further to a price that made the valuation $40m instead of $80m, its beta would have been greater. And to people who think beta measures risk, the cheaper price would have made it look riskier.

This is truly Alice in Wonderland. I have never been able to figure out why it’s riskier to buy $400m worth of properties for $40m than $80m.