Warren Buffett and Charlie Munger on Risk and Probability

Warren Buffett and Charlie Munger on Risk and Probability

The following is a transcript from a Berkshire Hathaway meeting where Warren Buffett was asked about his views on risk management for his company. He gave a thorough and detailed explanation of his thoughts on risk and probability.

“Can you please elaborate on your views on risk? You clearly aren’t a fan of relying on statistical probabilities, and you highlight the need for 20 billion dollars in cash to feel comfortable. Why is that the magic number, and has it changed over time?” asked Becky Quick.

Warren Buffett replied, “Yeah, well, it isn’t the magic number, and there is no magic number. I would get very worried about somebody that walked in every morning and told us precisely how many dollars of cash we needed to be secured to three sigma or something like that. But Charlie and I have had a lot of issues. We saw a lot of problems developing in an organization that expressed their risks in sigma, and we even argued sometimes with the appropriateness of how they calculated their risk.”

Charlie Munger interjected, “It was truly horrible.”

What does Warren Buffett say about risk?

Warren Buffett continued, “Yeah, and they were a lot smarter than we were. That’s what’s depressing. We both have the same band of mind whereby we think about worst cases all the time, and then we add on a big margin of safety. We don’t want to go back to go. I mean, I enjoy tossing those papers in the other room, but I don’t want to do it for a living again. So, we undoubtedly build in layers of safety that others might regard as foolish. But we’ve got six hundred thousand shareholders, and we’ve got members of my family that have 80 or 90 percent of their net worth in the company, and I’m just not interested in explaining to them that we went broke because there was a 100 to one percent chance that we would go broke, and the remaining probability was filled by the chance of doubling our money, and I decided that that was just not a good gamble to take. We’re not going to do that.”

Buffett explained, “It doesn’t mean that much. We are never going to risk what we have and need for what we don’t have and don’t need. We’ll still find things to do where we can make money, but we don’t have to stretch to do it. It’s my job, and Charlie thinks the same way. We don’t have to talk about it much, but it’s our job to figure out what can really go wrong with this place. We’ve seen September 11th, and we’ve seen September of 2008, and we’ll see other things of a different nature but similar impact in the future. And we not only want to sleep well on those nights, we want to be thinking about things to do with some excess money we might have around.”

Buffett continued, “So, if you’re calibrating it in some mathematical way, I would say it’s really dangerous. I could give you a couple of examples on that, but unfortunately, I’ve learned about them on a confidential basis. Some really great organizations have had dozens of people with advanced mathematical training and thinking about it daily, making daily computations, and they don’t really get at the problem.”

“It’s at the top of the mind always around Berkshire. Your returns in 99 years out of 100 will probably be penalized by us being excessively conservative, and one year out of 100, we’ll survive when some other people won’t. Charlie.”

Charlie Munger chimes in, “Yeah, but how do these super smart people with all these degrees and higher mathematics end up doing these dumb things?”

“I think it’s explainable by the old proverb that to a man with a hammer, every problem looks pretty much like a nail. They’ve learned these techniques, and they just twist the problem to fit the solution, which is not the way to do it.”

What is the danger of short selling?

Buffett adds, “And they have a lack of understanding of history. I would say that one of the things in 1962, when I set up our office at Kiewit Plaza where we still are, just on a different floor. I put seven items on the wall. Our art budget was seven dollars then. I went down to the library and for a dollar each, I made photocopies of pages from financial history. One of those cases, for example, was in May of 1901 when the Northern Pacific Corner occurred. It’s kind of interesting in terms of being in Omaha because Harriman was trying to get control of the Northern Pacific and James J. Hill was trying to control the Northern Pacific. Unbeknownst to each other, they both bought more than 50 percent of the stock. Now, when two people buy more than 50 percent of the stock each and they both really want it, they’re not just going to resell it. Interesting things happen.”

“To the shorts,” Munger interjected jokingly.

Buffet continued, “In that paper of May 1901, the whole rest of the market was totally collapsing because Northern Pacific went from 170 dollars a share to one thousand dollars a share in one day, trading for cash because the shorts needed it. There was a little item at the top of that paper which we still have at the office where a brewer in Troy, New York, committed suicide by diving into a vat of hot beer because he’d gotten a margin call.”

“To me, the lesson is that that fellow probably understood sigmas and everything and knew how impossible it was that one day a stock could go from 170 to a thousand, causing margin calls on everything else, and he ended up in the vat of hot beer. I’ve never wanted to end up in a vat of hot beer.”

“Those seven days that I put up on the wall, life, and financial markets, have got no relation to sigmas. I mean, if everybody that operated in financial markets had never had any concept of standard errors and so on, they would be a lot better off. Don’t you think so, Charlie?”

Charlie Munger on Risk Management

Munger answered, “Well, sure. It’s created a lot of false confidence, and now it has gone away again. As I said earlier, the business schools have improved, so has risk control on Wall Street. They now have taken the Gaussian curve and they just changed it. They threw it away. Well, they just made a different shape than Gauss did. It’s a better curve now, even though it’s less precise.

Buffett interjected, “They talk about fat tails, but they still don’t know how fat to make them. They have no idea.”

“Well, but they knew that they weren’t fat enough,” Munger replied.

“Yeah, they learned the other was wrong. Yeah, but they don’t know what’s right,” Buffett said.

“But we always knew that there were fat tails. Warren and I, at the Solomon meetings, would look over at one another and roll our eyes when the risk control people were talking,” Munger explained.[1]