Many academics and market participants measure the risk of investments by volatility, which indicates the strength of the price fluctuation of a financial instrument over a certain period of time and measures the uncertainty of the price fluctuation of the instrument, i.e. risk. Relative fluctuations indicate the risk of a stock. The more the value of an investment fluctuates, the riskier it is, according to theorists. Buffett and Munger define risk differently. For them, risk means the reasonable probability that an investment will produce a decrease in purchasing power.
Buffett has often quoted Benjamin Graham, saying that “in the short run, the market is a voting machine and in the long run, a measuring machine.” Price fluctuations describe the voting machine, but in the long run, the market follows the measuring machine, i.e. the success of the business. When an investor focuses on investing for the long term, he can forget about volatility and focus on making sure that he pays less for his investments than the present value of their future cash flows. Taking advantage of short-term price fluctuations by buying stocks at a lower price when prices are fluctuating downwards reduces long-term risks, as long as the investor does their homework and does not invest money they cannot afford to lose.
It is foolish to claim that buying a stock for a long-term investment today for 30 euros is less risky than buying it for 20 tomorrow if nothing has happened to the company's business or new information has emerged. In individual cases, anything can go wrong. The law of large numbers states that the relative accuracy of a hit should be the same as the probability of an event when samples are taken infinitely. Many investment decisions when the probabilities are on the investor's side will eventually show up as increasing returns for the investor.
An investor must evaluate probabilities through many possible outcomes, even if only one of them comes true. Estimates must be made based on the information at the time. When investing, probabilities are always relative estimates of the person making the investment. Probabilities change as investors gain new information. Every investment decision you make is based on estimates of probabilities, whether you calculate them or not. Using them, you can calculate the mathematical expected value of your investment's return. The simplest mathematical formula for expected value is as follows:
Expected value = probability of profit * its magnitude - probability of loss * its magnitude
Calculating probabilities is a more complicated process for investors, because in reality the magnitudes and probabilities of losses and profits vary more. According to Buffett, the most important factors when calculating probabilities are:
1. The probability with which the investor can assess the long-term financial development of the business.
2. The probability with which the investor can assess the ability of the management to exploit the opportunities offered by the business and to use the money circulating in it wisely.
3. The probability with which the management will distribute the rewards generated by the business to the owners instead of to itself.
4. The price paid for the business.
5. Much of the change in the investor's purchasing power from gross proceeds is reduced by taxation and inflation.
In the stock market, investors make a large number of decisions, all of which involve risk. Everyone must accept the risks and act accordingly. The best way to prepare for risk is to only invest money that you can afford to lose. In addition, focusing on long-term results reduces risk, because volatility reduces the probability of returns in the short term, but buying at a lower price increases the probability of returns in the long term with volatility. You can use the following chain of thought to reduce risk:
1. First calculate the probabilities
2. Wait for the best probabilities
3. Adapt to new information
4. Decide on the amount of money to invest
When calculating probabilities, the primary consideration is how likely this investment is to yield you more than alternative “risk-free” investments, such as long-term US government bonds or continuous savings in low-cost index funds. The less you can pay for a share compared to the present value of the probable future cash flows you have calculated, the more likely you are to succeed in your investment. In other words, the larger the safety margin, the better the opportunities and the lower the risks. The more uncertain your situation is, the larger the safety margin you need.
You will have to wait most of the time for the best opportunities, so you will get new information before making any potential investments. You will have to make new calculations about probabilities. You will have to answer the following questions, among others: Has something new happened to the company's competitiveness or its industry? Has the company's management started to behave differently towards the owners or has the management changed? Has its financial situation changed, etc. Probabilities change with the changes and you need to react to the changes.
Deciding on the amount of money to invest is an important part of the investment decision. The more the probabilities are on your side, the larger the amount of money you should invest. You will have to determine how much of your investable capital you will put into the investment. Your biggest risk is investing too much in a single target. This is a result of incorrectly assessed probabilities. You also have to deal with whether and how much leverage you should use. It can destroy your returns in the long run if you have to sell your investments too early because of your creditors. Leverage should always be used in a way that doesn’t destroy long-term investment opportunities. Good opportunities don’t come along often, so smart investors bet big when the odds are in their favor and wait it out otherwise.
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