BUFFETT: Volatility is not the same thing as risk, and anyone who thinks it is will cost themselves money

Warren buffett dairy queenDave Weaver/AP ImagesWarren Buffett.

Volatility and risk are not the same thing.

In his most recent annual letter to shareholders, Berkshire Hathaway CEO Warren Buffett wrote about the difference between the two, and how so many investors end up conflating these concepts and in turn costing themselves money.

Here’s Buffett:

The unconventional, but inescapable, conclusion to be drawn from the past fifty years is that it has been far safer to invest in a diversified collection of American businesses than to invest in securities — Treasuries, for example — whose values have been tied to American currency. That was also true in the preceding half-century, a period including the Great Depression and two world wars. Investors should heed this history. To one degree or another it is almost certain to be repeated during the next century.

Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments — far riskier investments — than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.

Over the last several years, a common refrain in markets is that volatility has all but evaporated, a phenomenon attributed to actions from central banks who sought calm, staid financial markets.

And the evidence for this claim has been the VIX, or the volatility index, which has been historically low over the last several years.

The problem with this conclusion is two-fold.

One, the VIX has been elevated at points over the last several months, particularly during the sell-offs seen in the fall of 2014 and at the start of this year. This is to be expected.

But the second part of this problem is that, as Buffett outlines, just because markets were volatile doesn’t mean that for a long-term investor — which is the prism through which Buffett sees markets — the stock market was necessarily riskier. (Take a look at the S&P 500 over the last six months and while you’ll see that gains have not come easily there have been gains.)

Buffett continues:

It is true, of course, that owning equities for a day or a week or a year is far riskier (in both nominal and purchasing-power terms) than leaving funds in cash-equivalents. That is relevant to certain investors — say, investment banks — whose viability can be threatened by declines in asset prices and which might be forced to sell securities during depressed markets. Additionally, any party that might have meaningful near-term needs for funds should keep appropriate sums in Treasuries or insured bank deposits.

For the great majority of investors, however, who can — and should — invest with a multi-decade horizon, quotational declines are unimportant. Their focus should remain fixed on attaining significant gains in purchasing power over their investing lifetime. For them, a diversified equity portfolio, bought over time, will prove far less risky than dollar-based securities.

Right now, markets are obsessed with what the Federal Reserve will do. And rightly so. The Fed hasn’t raised rates since July 2006, and if they don’t raise rates at their June policy meeting, which is the
absolute earliest the Fed has signalled it would be willing to raise rates, then it will likely cross over the nine year mark without any changes to its main interest rate.

And so in short, markets are in for a big shock, whenever the Fed does move.

No matter when the Fed acts, it will likely make markets a bit turbulent. But the turbulence is entirely different for bond traders who trade the short end of the Treasury curve and those who are investing in stocks for retirement. For the short-end bond trader, the Fed’s actions could not matter more: this is as big a deal as it gets. This is a volatility and a risk event.

For a long-term stock investor, however, the volatility created by any Fed action doesn’t really constitute a risk event. Not unless you do act during that period, for which Buffett or a like-minded investor might invoke the old saying: “Don’t just do something, sit there.”

NOW WATCH: Warren Buffett is in the new trailer for the ‘Entourage’ movie

Business Insider Emails & Alerts

Site highlights each day to your inbox.

Follow Business Insider Australia on Facebook, Twitter, LinkedIn, and Instagram.