UNDERSTANDING ‘BETA’ AND INVESTING

Buffett points out the absurdity of beta by observing that “a stock that has dropped very sharply compared to the market … becomes ‘riskier’ at the lower price than it was at the higher price”-that is how beta measures risk. Equally unhelpful, beta cannot distinguish the risk inherent in “a single-product toy company selling pet rocks or hula hoops from another toy company whose sole product is Monopoly or Barbie.”

Volatility does not measure risk. The problem is that the people who have written about and taught volatility do not understand risk. Beta is nice and mathematical, but it’s wrong. Past volatility does not determine risk. Take farmland here in Nebraska: the price of land went from $2,000 to $600 per acre. The beta of farms went way up, so according to standard economic theory, I was taking more risk buying at $600. Most people would know that’s nonsense because farms aren’t traded. But stocks are traded and jiggle around and so people who study markets translate past volatility into all kinds of measures of risk: BRK Annual Meeting

All true investing must be based on an assessment of the relationship between price and value. Strategies that do not employ this comparison of price and value do not amount to investing at all, but to speculation-the hope that price will rise, rather than the conviction that the price being paid is lower than the value being obtained. Many professionals make another common mistake, Buffett notes, by distinguishing between “growth investing” and “value investing.” Growth and value, Buffett says, are not distinct. They are integrally linked since growth must be treated as a component of value.

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