More Praise for The Warren Buffett Way, First Edition

modern portfolio theor y.
Be-
cause this is a book about Buffett’s thinking, and because Buffett him-
self does not subscribe to this theory, we will not spend much time
describing it. But as you continue to learn about investing, you will
hear about this theory, and so it is important to cover its basic elements.
Then we’ll give Buffett a chance to weigh in on each.
Modern portfolio theory is a combination of three seminal ideas
about finance from three powerful minds. Harry Markowitz, a graduate
student in economics at the University of Chicago, first quantified the
relationship between return and risk. Using a mathematical tool called
covariance, he measured the combined movement of a group of stocks,
and used that to determine the riskiness of an entire portfolio.
Markowitz concluded that investment risk is not a function of how
much the price of any individual stock changes, but how much a group
of stocks changes in the same direction. If they do so, there is a good
chance that economic shifts will drive them all down at the same time.
The only reasonable protection, he said, was diversif ication.
About ten years later, another graduate student, Bill Sharpe from
the University of California-Los Angeles, developed a mathematical
process for measuring volatility that simplif ied Markowitz’s approach.
He called it the Capital Asset Pricing Model.
So in the space of one decade, two academicians had def ined two
important elements of what we would later come to call modern port-
folio theory: Markowitz with his idea that the proper reward/risk bal-
ance depends on diversif ication, and Sharpe with his def inition of
risk. A third piece—the eff icient market theory ( EMT)—came from
a young assistant professor of f inance at the University of Chicago,
Eugene Fama.
Fama began studying the changes in stock prices in the early 1960s.
An intense reader, he absorbed all the written work on stock market be-
havior then available and concluded that stock prices are not predictable
because the market is too efficient. In an efficient market, as informa-
tion becomes available, a great many smart people aggressively apply that
information in a way that causes prices to adjust instantaneously, before
anyone can profit. At any given moment, stock prices ref lect all available
information. Predictions about the future therefore have no place in an
efficient market, because the share prices adjust too quickly.

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M a n a g i n g Yo u r P o r t f o l i o
1 6 5
Buffett’s View of Risk
In modern portfolio theory, the volatility of the share price defines risk.
But throughout his career, Buffett has always perceived a drop in share
prices as an opportunity to make money. In his mind, then, a dip in price
actually reduces risk. He points out, “For owners of a business—and
that’s the way we think of shareholders—the academics’ definition of
risk is far off the mark, so much so that it produces absurdities.”
9
Buffett has a different definition of risk: the possibility of harm.
And that is a factor of the intrinsic value of the business, not the price
behavior of the stock. Financial harm comes from misjudging the fu-
ture prof its of the business, plus the uncontrollable, unpredictable effect
of taxes and inf lation.
Furthermore, Buffett sees risk as inextricably linked to an investor’s
time horizon. If you buy a stock today, he explains, with the intention
of selling it tomorrow, then you have entered into a risky transaction.
The odds of predicting whether share prices will be up or down in a
short period are the same as the odds of predicting the toss of a coin;
you will lose half of the time. However, says Buffett, if you extend your
time horizon out to several years (always assuming that you have made
a sensible purchase), then the odds shift meaningfully in your favor.
Buffett’s View of Diversification
Buffett’s view on risk drives his diversif ication strategy, and here, too,
his thinking is the polar opposite of modern portfolio theory. Accord-
ing to that theory, the primary benef it of a broadly diversif ied portfo-
lio is to mitigate the price volatility of the individual stocks. But if you
are unconcerned with price volatility, as Buffett is, then you will also
see portfolio diversif ication in a different light.
He knows that many so-called pundits would say the Berkshire
strategy is riskier, but he is not swayed. “We believe that a policy of
portfolio concentration may well