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4 Investment Risks Warren Buffett Says You Should Not Take

What does risk mean to you...and Warren Buffett? 

 

If you ask the average person, they’re likely to say the probability of losing money. If you ask most financial professionals, they’ll probably equate risk with volatility of returns. (While these may sound similar, they’re not exactly the same thing.) For example.

 
Let’s say investment A loses 3% one year and gains 2% the next and investment B gains 5% one year and 20% the next. Most people would call investment A riskier since it lost money while financial professionals would say investment B is riskier because the rerns were more variable.) But if you ask Warren Buffett, the second richest American and widely considered the greatest investor alive today, he would say they're both wrong.

In his most recent annual letter to shareholders, Buffett wrote:
“Volatility is far from synonymous with risk… If the investor…fears price volatility, erroneously viewing it as a measure of risk, he may, ironically, end up doing some very risky things.”
Instead of volatility, Buffett measures risk as the loss of purchasing power or basically how much you can actually buy with that money, which is the whole point of actually having it.
 
So what are those “very risky” things investors may do by focusing on volatility? Here are 4 that Buffett mentions and what you should do instead:
 
 
1) Keeping long term money in cash.

Many people keep most or even all of the long term money in cash because they're afraid of market volatility. Buffett admits 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,” but he argues that over the long term, “a diversified equity portfolio, bought over time, will prove far less risky than dollar-based securities.” That’s because in the long run, the erosion of the value of your money due to inflation is much more devastating that the short term fluctuations in the stock market.

Average money-market rates are less than a tenth of a percentage point while the average inflation rate last year was 1.6%. That means, the real value of your cash is decreasing by about 1.5% a year. In the short run, that’s a lot less than what you could lose in stocks but in 10 years, your money will have lost almost a quarter of its purchasing power. Compare that to the S&P 500, a selection of 500 of the largest companies in the US, which more than doubled with dividends reinvested over the last 10 years despite the financial crisis in 2008.
 
Bottom Line: Match your investments to your time frame.

2) Not being adequately diversified.

Another mistake is people having too much in one stock. Often its their employer's stock or the stock received in exchange of a sold company. Sometimes it’s a majority or even all of their money in one stock. There are lots of different reasons. They may know and trust their employer and don’t understand or trust their other options. This stock may have been performing particularly well. The employer stock may be one option out of several in their retirement plan and by spreading their money around, they may inadvertently put too much in their employer stock. They may have acquired the stock as a gift or inheritance or from options, grants, or an employee stock purchase plan and they don’t know what to do with it.

Regardless of the reason, any individual stock (no matter how good the company) is inherently very risky. Unlike what Buffett calls a “diversified equity portfolio” an individual stock can go to zero and never come back. That’s not volatility. That’s a permanent loss of purchasing power.

Bottom Line: Make sure you own a larger number of individual stocks in a a variety of industries or stick to broad-based mutual funds or ETFs that diversify the money for you.
 
3) Attempting to “time” the market.

Although not thought often as such, this is one of the most common investor mistakes. How many times have you heard people say that they know the market will decline and are waiting until then to jump in. Yes, it’s true that the market will decline at some point. The problem is that no one knows when. 
 
As Buffett puts it,
“Anything can happen anytime in markets. And no advisor, economist, or TV commentator – and definitely not Charlie nor I – can tell you when chaos will occur. Market forecasters will fill your ear but will never fill your wallet.”
Bottom Line: Instead of trying to time the market (which even Warren Buffett doesn't try to do), make sure you have adequate time IN the market, as that is what matters most.
 
4) Active trading.

Instead of trying to time the market, others try to beat it by trading stocks they believe will outperform the market as a whole. This belief can be strengthened if an investor has one or more lucky trades. In many of these situations, the investor mistakes a rising market for his or her investing prowess.

However, many economists believe that the stock market is essentially efficient, which means that it’s extremely difficult if not virtually impossible to beat over the long run. Even if you don’t subscribe to this theory, it’s noteworthy that the vast majority of professional mutual fund managers consistently under-perform the market. Even the few that do outperform over a given time period are actually less likely than average to do so over the next same time period. In other words, any out-performance may be due to luck, exactly what the economists would have predicted.

So if not higher performance, what does all this trading produce? One study found that all this trading costs the average mutual fund about 1.44% per year. That loss comes out of your pocket but is not included in any of the fees reported by mutual funds.

Bottom Line: If professional investment managers, many from top business schools, with access to cutting-edge research and teams of research analysts working for them are unable to consistently beat the market, what makes you think you can? Instead of actively trying to beat the market, limit your trading to making sure your portfolio matches your time frame and risk tolerance, harvest tax losses to offset taxable gains, or switch from higher cost funds to lower cost funds.

 
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