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Buffett explains why volatility is not risk and why equity is best

In his annual letter last year, Warren Buffett explained why mistaking volatility for risk prevents savers from realising that equity is the best investment

It's that time of the year again when Warren Buffett's fan eagerly wait for the pearls of wisdom that the master drops. Around this time of the year, Buffett writes his annual letter to the shareholders of his holding company, Berkshire Hathaway. Besides writing about the companies' performance, the doyen of equity investors always writes entertainingly about a range of business and financial issues.

While those who were looking at his letter for a revelation of who would run Berkshire after him were disappointed, those awaiting a package of wit and wisdom about business and investing were not.

One of the most interesting passages in the letter last year was about the superiority of equity investing over the long term. Here's what Buffett says:

Our investment results have been helped by a terrific tailwind. During the 1964-2014 period, the S&P 500 rose from 84 to 2,059, which, with reinvested dividends, generated the overall return of 11,196% ... Concurrently, the purchasing power of the dollar declined a staggering 87%...

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 ... 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.

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. 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... If the investor, instead, fears price volatility, erroneously viewing it as a measure of risk, he may, ironically, end up doing some very risky things.

Investors, of course, can, by their own behavior, make stock ownership highly risky. And many do. Active trading, attempts to "time" market movements, inadequate diversification, the payment of high and unnecessary fees to managers and advisors, and the use of borrowed money can destroy the decent returns that a life-long owner of equities would otherwise enjoy."

What Buffett says here is a simple message, and yet that has proven really, really hard to understand. In fact, it's far less understood in India than in the US. The idea that the volatility is a measure of risk only with reference to a particular time frame is unknown outside a small proportion of investors. We accept without question that equity is riskier than fixed income investments. Some of us qualify this a bit, others equate equity with gambling. In India, we have an investing environment where real (inflation-adjusted) returns from fixed income are tiny, and real return from equity have been huge. A general attitude that equity is unacceptably risky except for dabbling by rich punters does lasting damage to the investing portfolios of most Indians.

This story first appeared in March 2015.

Catch Buffett and Munger live on April 30.

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