The following portfolio management related excerpts are extracted from Superinvestors of Graham-and-Doddsville, an article based on a speech Warren Buffett gave at Columbia Business School on May 17, 1984
Risk, Expected Return. Volatility
“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 it once? If you survive, I will give you $1 million.’ I would decline – perhaps stating that $1 million is not enough. Then he might offer me $5 million 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 60 cents, it’s riskier than if you buy a dollar bill for 40 cents, 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 $80 million in the market. At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more. The company owned the Post, Newsweek, plus several television stations in major markets. Those same properties are worth $2 billion now so the person who would have paid $400 million would not have been crazy.
Now if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, 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 $400 million worth of properties for $40 million and $80 million.”
Risk and reward is not always positively correlated, as traditional financial theory seems to suggest. (For further elaboration on this relationship, be sure to read Chapter 5 of Howard Marks’ book.)
On volatility, although Buffett doesn’t use historical volatility (historical beta) as a measure of risk when determining which securities to purchase, he never explicitly says that investors should ignore future volatility.
Perhaps this is the distinction – observed historical volatility vs. anticipation of future volatility – that reconciles value investing and volatility (price movement) considerations.
Historical volatility should not play a central role in investment decisions (because historical volatility is a bad predictor of future outcome). However, investors (even those from Graham-&-Doddsville) should pay attention to and anticipate future volatility because it impacts the portfolio return stream, as well as other cash, opportunity cost, and firm management considerations.
Expected Return, AUM
“When I wound up Buffett Partnership I asked Bill [Ruane] if he would set up a fund to handle all of our partners so he set up the Sequoia Fund…Bill was the only person I recommended to my partners, and I said at the time that if he achieved a four point per annum advantage over the Standard & Poor’s, that would be solid performance. Bill has achieved well over that, working with progressively larger sums of money. That makes things much more difficult. Size is the anchor of performance. There is no question about it.”
During the Partnership days (starting around 1957), Buffett’s goal was to beat the Dow by 10% annually over a long period of time. By 1970, based on the quote above, Buffett thought a 4% annual outperformance over the S&P would be “solid.”
The decline in expected return is either an indication that (1) Buffett believed he could achieve higher returns than Bill Ruane, or (2) Buffett’s portfolio expected return changes with the market environment – with the latter as the more probable explanation.
This idea of shifting expected return is directly applicable to the “equities = annual 8% return” mentality that’s still prevalent among investors today, and fueling all sorts of problems. Ahem, pensions. Future investment returns are a function of market environments and available purchase price, not previously determined or historical return rates – this is true for all investors, including Warren the Great.
Interestingly, Buffett’s expected return figure seems to have declined even further in recent days. At the 2012 Berkshire meeting, to roughly paraphrase Buffett (based on notes taken by Ben Claremon, the Innoculated Investor):
“Todd [Combs] and Ted [Weschler] get a few million dollars in salary and then get 10% of how much they beat the S&P by. This is measured on a rolling, 3 year basis.”
The margin of outperformance above the S&P or Dow has now altogether disappeared. Today, the goal is simply to beat the index.
On AUM, Buffett knew/believed from the very beginning (we see evidence of this circa 1963 in the Partnership letters) that increasing assets under management can lead to declining performance. We see this again above in this statement that “size is the anchor of performance.”
So, why then did Berkshire get so big? Or was this AUM-Performance rule only true “on average,” and talented investors were exempt?