The Stock Market is a device for transferring money from the impatient to the patient…. Warren Buffett
The Stock Market is a device for transferring money from the impatient to the patient…. Warren Buffett
Successful Investing takes time, discipline and patience. No matter how great the talent or effort, some things just take time: You can’t produce a baby in one month by getting nine women pregnant. ~ Buffett
In an inflationary world, a toll bridge (like company) would be a great thing to own because you’ve laid out the capital costs. You built it in old dollars and you don’t have to keep replacing it. ~ Warren Buffett
Investors generally focus on the returns of any asset. They largely ignore the risk factors and most importantly are ignorant of the measures of risk.
And so, the real Risk comes from not knowing what they are doing ~ Warren Buffett
This post talks about the measures of risks in equities & debt. The awareness of the measures of risk is extremely helpful in designing a comprehensive financial plan, investing, asset allocation etc.
Fluctuation in returns is used as a measure of risk.
Therefore, to measure risk, generally the periodic returns (daily / weekly / fortnightly / monthly) are first worked out, and then their fluctuation is measured.
The fluctuation in returns can be assessed in relation to itself, or in relation to some other index. Accordingly, the following risk measures are commonly used.
Suppose there were two stocks, with monthly returns as follows: Stock 1: 5%, 4%, 5%, 6%. Average=5% & Stock 2: 5%, -10%, +20%, 5% Average=5%
Although both stocks have the same average returns, the periodic (monthly) returns fluctuate a lot more for Stock 2. Variance measures the fluctuation in periodic returns of a asset, as compared to its own average return. This can be easily calculated in MS Excel using the following function:
=var(range of cells where the periodic returns are calculated)
Variance as a measure of risk is relevant for both debt and equity.
Like Variance, Standard Deviation too measures the fluctuation in periodic returns of a scheme in relation to its own average return. Mathematically, standard deviation is equal to the square root of variance.
This can be easily calculated in MS Excel using the following function: =stdev(range of cells where the periodic returns are calculated)
Standard deviation as a measure of risk is relevant for both debt and equity schemes.
Beta is based on the Capital Assets Pricing Model, which states that there are two kinds of risk in investing in equities – systematic risk and non-systematic risk.
Systematic risk is integral to investing in the market; it cannot be avoided. For example, risks arising out of inflation, interest rates, political risks etc.
Non-systematic risk is unique to a company; the non-systematic risk in an equity portfolio can be minimized by diversification across companies. For example, risk arising out of change in management, product obsolescence etc.
Since non-systematic risk can be diversified away, investors need to be compensated only for systematic risk. This is measured by its Beta.
Beta measures the fluctuation in periodic returns in a scheme, as compared to fluctuation in periodic returns of a diversified stock index over the same period.
The diversified stock index, by definition, has a Beta of 1. Companies or schemes, whose beta is more than 1, are seen as more risky than the market. Beta less than 1 is indicative of a company or scheme that is less risky than the market.
Beta as a measure of risk is relevant only for equity schemes.
This measures the sensitivity of value of a debt security to changes in interest rates. Higher the modified duration, higher the interest sensitive risk in a debt portfolio.
The returns in a debt portfolio are largely driven by interest rates and yield spreads.
Suppose an investor has invested in a debt security that yields a return of 8%. Subsequently, yields in the market for similar securities rise to 9%. It stands to reason that the security, which was bought at 8% yield, is no longer such an attractive investment.
It will therefore lose value. Conversely, if the yields in the market go down, the debt security will gain value. Thus, there is an inverse relationship between yields and value of such debt securities which offer a fixed rate of interest.
A security of longer maturity would fluctuate a lot more, as compared to short tenor securities. Debt analysts work with a related concept called modified duration to assess how much a debt security is likely to fluctuate in response to changes in interest rates.
In a floater, when yields in the market go up, the issuer pays higher interest; lower interest is paid, when yields in the market go down. Since the interest rate itself keeps adjusting in line with the market, these floating rate debt securities tend to hold their value, despite changes in yield in the debt market.
If the portfolio manager expects interest rates to rise, then the portfolio is switched towards a higher proportion of floating rate instruments; or fixed rate instruments of shorter tenor. On the other hand, if the expectation is that interest rates would fall, then the manager increases the exposure to longer term fixed rate debt securities.
The calls that a fund manager takes on likely interest rate scenario are therefore a key determinant of the returns in a debt fund – unlike equity, where the calls on sectors and stocks are important.
Suppose an investor has invested in the debt security of a company. Subsequently, its credit rating improves. The market will now be prepared to accept a lower yield spread. Correspondingly, the value of the debt security will increase in the market.
A debt portfolio manager explores opportunities to earn gains by anticipating changes in credit quality, and changes in yield spreads between different market benchmarks in the market place.
Weighted Average Maturity
While modified duration captures interest sensitivity of a security better, it can be reasoned that longer the maturity of a debt security, higher would be its interest rate sensitivity. Extending the logic, weighted average maturity of debt securities in a scheme’s portfolio is indicative of the interest rate sensitivity of a scheme.
Being simpler to comprehend, weighted average maturity is widely used, especially in discussions with lay investors. However, a professional debt fund manager would rely on modified duration as a better measure of interest rate sensitivity.
Buffett’s disdain for gold as an investment asset is very well known. Here is a quote from one of the world’s greatest investor on investing in Gold :
Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head. ~ Warren Buffett
The Rules for Success in Investing
Rule No. 1 : Never lose money.
Rule No. 2 : Never forget rule no. 1
~ Warren Buffett
“In Investing, just as in Baseball, to put runs on the scoreboard, one must watch the playing field, not the scoreboard.” ~ Warren Buffett
The following is a transcript of 2008- Berkshire Hathaway Shareholders meeting at Omaha, Nebraska
It is worth a read … Wonderful thoughts from the Oracle of Omaha, Warren Buffett
What does it take to become a successful investor? Brilliance or Smartness?
Neither, Success in investing doesn’t correlate with I.Q. Once you have ordinary intelligence, what you need is the temperament to control the urges that gets other people into trouble in investing.
When do you deicide to invest in a firm?
The best thing that happens to us is when a great company gets into temporary trouble. We want to buy them when they’re on the operating table. (Mr. Buffett bought Coke when it had its biggest fiasco after launching New Coke; he bought American Express when it went through a loss making phase in the early 60’s)
What do you look for in people when they come to sell their firms to you?
I don’t look for the usual credentials such as an MBA, a pedigree (Harvard, Wharton), or cash reserves or market cap of their firm. What I look for is just a passion in their eyes; I think that’s the key. A person who is hungry will always do well. I prefer it when people evenafter selling stay on and work for the firm; they are people who can’t wait to get off their bed to get to work. Passion is everything; there is no replacement for innate interest.
Mr. Buffett, you told us that Berkshire Hathaway has $ 45 Billion in cash. Why aren’t you investing?
Up until a few years back I had more ideas than money. Now I have more money than ideas.
When do you plan to retire?
I love my job; I love it so much that I tap dance to work. Mrs. B, the founder of Nebraska Furniture Mark worked until she was 104, she died within 6 months of her retirement, that’s a lesson to all my managers, don’t retire! I personally am going to work 6-7 years after I die, probably that’s what they mean when they say- “Thinking out of the Box”!!
Why do stock market crashes happen?
Because of human nature for greed and insecurity. The 1970s were unbelievable. The world wasn’t going to end, but businesses were beinggiven away. Human nature has not changed. People will always behave in a manic-depressive way over time. They will offer great values to you.”
What are the things that are taught wrong in Business school and the corporate world?
I like such open ended questions, I think Business schools should refrain from teaching their wards about profit making and profit making alone, it gives a sense of 1 dimensional outlook to the young students that loss is a curse. In reality, in the corporate world, failure and loss making are inevitable. The capital market without loss is like Christianity without hell. I think they should teach the student on how to buy a business, how to value a business? Not just on how to determine the price of a business. Because price is what you pay, value is what you get.
Do you still hate Technology stocks?
With Coke I can come up with a very rational figure for the cash it will generate in the future. But with the top 10 Internet companies,how much cash will they produce over the next 25 years? If you say you don’t know, then you don’t know what it is worth and you arespeculating, not investing. All I know is that I don’t know, and if I don’t know, I don’t invest.”
How to think about Investing?
The first investment primer was written by Aesop in 600 B.C. He said, ‘A bird in the hand is worth two in the bush.’ Aesop forgot to saywhen you get the two in the bush and what interest rates are; investing is simply figuring out your cash outlay (the bird in the hand) and comparing it to how many birds are in the bush and when you get them.”
How do you feel after donating $ 40 Billion to the Bill and Melinda Gates foundation? You are a hero to us!
I feel nothing. I haven’t sacrificed anything in life. I have had a good life. I donated after I turned 75. I think I admire those people who sacrifice their time, share their food and home, as the people to be emulated not me. Besides, what is money before a man’s life?
What do you think are the pitfalls in donation?
I have never donated a dime to churches or other such organizations; I need to believe in something before I end up doing that. I have beenobserving the Bill & Melinda Gates foundation for years now and I am confident they will do a fantastic job of making use of the money. I am a big believer in Outsourcing, others believed in me as an Investor and gave their hard earned money to invest. I believe in Bill Gates, he is a better donor than me.
Why do you work from Omaha and not Wall Street, New York?
Wall Street is the only place where people alight from Rolls Royce to get advised by people who use the Public transportation system.
You seem to be so well read, tell us how it all started.
My father was a stock broker, so we had all these financial books in our library. He introduced me to those classics and I got into them. Iam lucky that my father was not a fan of Playboy! Reading is the best habit you can get. Well, you can learn from teachers too, and have mentors but there are so many constraints attached- they will talk fast, talk slow, they might talk like a pro or they might be terrible communicators. Books are a different animal altogether, I love reading! The beauty about reading and learning is that the more you learn the more you want to learn.
Excellent Quotes by Warren Buffet
On Earning: “Never depend on single income. Make investment to create a second source.”
On Spending: “If you buy things you do not need, soon you will have to sell things you need.”
On Savings: “Do not save what is left after spending, but spend what is left after saving.”
On Taking Risk: “Never test the depth of river with both the feet.”
On Investment: “Do not put all your eggs in one basket.”
On Expectations: “Honesty is very expensive gift. Do not expect it from cheap people.”
Here are 5 valuable tips for investing from Warren Buffett – The Master of Value Investing. 1. “Look at stocks as parts of business. Ask yourself, ‘How would I feel if the Stock Exchange was closing tomorrow for the next three years?’ If I am happy owning the stock under that circumstance, I am happy with the business. That frame of mind is important to investing.” 2. “The market is there to serve you and not to instruct you. It is not telling you whether you are right or wrong. The business results will determine that.” 3. “You can’t precisely know what a stock is worth, so leave yourself a margin of safety. Only go into things where you could be wrong to some extent and come out OK.” 4. “Borrowed money is the most common way that smart guys go broke.” 5. “The stock doesn’t know you own it. You have feelings about it, but it has no feelings about you. The stock doesn’t know what you paid. People shouldn’t get emotionally involved with their stocks.” Happy Investing…
Investing is simple but not easy ~ Warren Buffett