Buffett’s “Avoid Risk” investment philosophy
Introduction
To avoid investment mishaps, Miles (2004) advises that it is important to come up with guiding principles that should act as an investment philosophy. Great investors in the stock market such as Warren Buffett have concrete principles that have guided them over many decades. Buffett, CEO Hathaway Berkshire, is guided by a number of investment principles with “Avoid risk” being among them. This is a fascinating principle that clearly outlines the path to take in avoiding risks and rightly investing in successful holdings. This paper presents Buffett’s “Avoid Risk” investment philosophy. Specifically, the aspect of investing in business which one clearly understands and remaining within the business circle is discussed. The element of trading away a big payoff for a certain payoff is also highlighted as a crucial aspect of avoiding risk. Finally, the aspect of avoiding risks by concentrating on only a few holdings is focused in this paper.
Buffett’s “Avoid Risk” philosophy
The “Avoid Risk” philosophy is conscious about the fact that efficient markets have lower risks compared to inefficient markets. Contrary to the views of many academics in economics, Buffett refutes the idea that “risk is the same as volatility” (Graham & Dodd, 2008, p. xxxii) and instead insists that assessing risks is a vital decision in investing. In fact Buffett is of the view that it is important to know the history of a company’s past performance before investing in the company. Sufficient knowledge about a company helps not only in identifying potential risks but also spotting likely opportunities (Stock Market Investors, 2010). One aspect of understanding past performance of a company is that it helps in predicting possible risks of investing in the company. Buffett stresses the importance of staying liquid as another means of avoiding risks. For instance, Berkshire Hathaway Limited has liquidity exceeding $40 billion (Buffett, 2007) thus cash is always available to serve any financial need that may arise. Therefore, risk-averse investors should have enough information about the history of a company before investing in the company.
For one to effectively avoid risks when considering investing, Buffett advises that a good investor should consider investing in businesses that one has accurate information about. This involves investing in ventures that one can forecast future cash flows with greater certainty. It is not advisable to make investments in business whose future is unpredictable even if the business is currently fairing well. This means that the current performance of a company should not be used as a yardstick to measure future performance. On another note, Miles (2004) mentions that Buffett always considers analyzing financial reports for companies that he intends to invest in. This is in line with his statement that “risks comes from not knowing what you are doing” (Ramsey, 2010, p. 210). In case Buffett does not grasp the contents of the financial reports, he always keeps off from investing in such companies.
Buffett prefers investing in portfolios which have constant returns in the long-term. In his circle of business investments, he avoids investing in industries which do not have a predictable pattern of performance. For instance, Buffett avoids investing in high technology since it is a dynamic industry which cannot be predicted with certainty. Berkshire Hathaway Ltd. deals with investments which are rarely affected by changes in technology. Such dealings include footwear, real estate, jewellery, home furnishings, and underwriting property among others. Buffett is not particularly interested in investing in high technology companies and instead prefers trading away a big payoff for a certain payoff. It is therefore no wonder that Berkshire Hathaway Ltd. has large share investments in companies such as Coca-Cola, McDonalds, Gillette and Dairy Queen among others (Buffett, 2007).
It is important to note that Buffett’s “Avoid Risk” principle recognizes that risks can be reduced significantly by concentrating on only a few holdings. This is preferable since it makes it easy to monitor the performance of each holding and to respond to market changes effectively. Buffet ensures that Berkshire Hathaway Ltd. engages in only a few but large business portfolios in a year as a way of avoiding risks (Fat Pitch Financials, 2005).
In conclusion, Buffett’s “Avoid Risk” investment philosophy is a commendable investment principle since it has kept him in the stock market for more than fifty years. Having sufficient information about a company helps understand the past, present and the future performance of the company. It is therefore agreeable that full knowledge of a company forms the best platform for decision making on whether to invest in the company. It is important to note that even if Buffett advises not to invest outside the circle, he does not rule out diversification as long as you remain within the business circle. As such, his “Avoid Risk” philosophy is not completely restrictive. However, Buffett’s “Avoid Risk” philosophy can be criticized on the fact that diversifying in portfolios reduces risk levels in investment. This is contrary to the Buffett’s aspect of concentrating on only a few holdings.
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