In the age of cryptocurrencies, NFTs, and meme stocks, the pearls of wisdom from one of the greatest investors of all time, Warren Buffett, are more poignant and relevant than ever. He explained the concepts of investing and risks eloquently in “The Basic Choices for Investors and the One We Strongly Prefer”, a section in Berkshire Hathaway’s 2011 Chairman’s letter. We believe individual investors can benefit greatly from Mr. Buffett’s advice.
On Investing and Risks
Mr. Buffett first defined the process of investing with a clear focus on its purpose.
“Investing is often described as the process of laying out money now in the expectation of receiving more money in the future. At Berkshire we take a more demanding approach, defining investing as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power – after taxes have been paid on nominal gains – in the future.”
He then proceeded to define risk, which differs from the financial service industry’s definition.
“From our definition there flows an important corollary: The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability – the reasoned probability – of that investment causing its owner a loss of purchasing-power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. And as we will see, a non-fluctuating asset can be laden with risk. “
Tell your investment advisor this: “ Beta or Volatility is not equivalent to Risk!”
Three Categories of Investments
Mr. Buffett went on to classify investments into three categories.
Category I – “Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as “safe.” In truth, they are among the most dangerous of assets. Their beta may be zero, but their risk is huge. “
The key risk, of these “safe” investments, is due to inflation and the loss of purchasing power, despite timely payment of interests and principal. This risk is even more pronounced in a low-interest rates environment, as we are facing today. Investors who are advised to allocate their portfolio based on a 60%/40% stocks and bond split need to be particularly aware of the true risks they are taking.
Category II– “assets that will never produce anything, but that are purchased in the buyer’s hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future.”
Mr. Buffett explained that “This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce – it will remain lifeless forever – but rather by the belief that others will desire it even more avidly in the future. “
The Tulips in the 17th century and the current Cryptocurrencies and NFTs seem to fit into this category nicely. Putting money in this category is a dangerous game for individuals. The expansion of the buying pool will eventually stop and the true value of the lifeless assets always settle at levels way below the peak valuations.
Category III – Mr. Buffett’s preference – “investment in productive assets, whether businesses, farms, or real estate. Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment. “
This is his rationale for picking this category. “Our country’s businesses will continue to efficiently deliver goods and services wanted by our citizens. Metaphorically, these commercial “cows” will live for centuries and give ever greater quantities of “milk” to boot. Their value will be determined not by the medium of exchange but rather by their capacity to deliver milk. Proceeds from the sale of the milk will compound for the owners of the cows, just as they did during the 20th century when the Dow increased from 66 to 11,497 (and paid loads of dividends as well). Berkshire’s goal will be to increase its ownership of first-class businesses. Our first choice will be to own them in their entirety – but we will also be owners by way of holding sizable amounts of marketable stocks. I believe that over any extended period of time this category of investing will prove to be the runaway winner among the three we’ve examined. More important, it will be by far the safest. “
Follow Mr. Buffett’s Advice
Individuals should follow Mr. Buffett’s advice and invest in productive assets with a long-term view. If you do not have the access or the know-how to invest in farms or real estate, you can become partial owners of businesses by owning shares of public companies. For those who do not have the time or the temperament to do fundamental research, you can buy a low-cost diversified index ETF. We prefer to do research, pick “first-class businesses” and construct customized portfolios for individuals with specific goals. Whatever the approach, holding productive businesses over a long period is the safest way for individuals to gain and grow wealth.