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Warren Buffett: Risk, Volatility and Farmland

- By Rupert Hargreaves

Warren Buffett (Trades, Portfolio) does not associate volatility with risk. This has been part of his investment strategy virtually since the beginning, and he's never going to change.

Volatility and risk are separate things. A volatile stock price does not necessarily mean that the company is riskier than any other business and vice versa.

Indeed, I reckon a large percentage of the thinly traded small caps at the bottom of the market are probably the market's least volatile stocks, but that by no means makes them less risky. On balance, they are probably riskiest of all public companies.

Buffett's favorite way of describing the difference between risk and volatility is his farm analogy. He likes to say that you don't buy a farm based on whether or not it is going to be worth more tomorrow or a week from now. You buy it as a business -- for the cash flows it will generate.

In the Berkshire Hathaway (BRK-A)(BRK-B) 2007 shareholder meeting, Buffett told his investors:

"I mean, actually, take it with farmland. Here in 1980, or in the early 1980s, farms that sold for $2,000 an acre went to $600 an acre. I bought one of them when the banking and farm crash took place."

Now, according to market theory, this price crash implies farmland is riskier:

"And the beta of farms shot way up. And, according to standard economic theory or market theory, I was buying a much more risky asset at $600 an acre than the same farm was at 2,000 an acre."

But, because the prices of farmland are not displayed on a second-by-second basis publicly, most landowners would think that this concept is insane, and certainly not worth all the time and effort Wall Street analysts spend analyzing beta:

"Now, people, because farmland doesn't trade often and prices don't get recorded, you know, they would regard that as nonsense, that my purchase at $600 an acre of the same farm that sold for 2,000 an acre a few years ago was riskier."

Unfortunately, the same cannot be said for stocks:

"But in stocks, because the prices jiggle around every minute, and because it lets the people who teach finance use the mathematics they've learned, they have -- in effect, they would explain this a way a little more technically -- but they have, in effect, translated volatility into all kinds of -- past volatility -- in terms of all kinds of measures of risk."

This kind of risk analysis is, in Buffett's words, nonsense, and you could argue that it lulls investors into a false sense of security when it comes to analyzing company-specific risk:

"Risk comes from the nature of certain kinds of businesses. It can be risky to be in some businesses just by the simple economics of the type of business you're in, and it comes from not knowing what you're doing.

And, you know, if you understand the economics of the business in which you are engaged, and you know the people with whom you're doing business, and you know the price you pay is sensible, you don't run any real risk."

I'm sure many readers of this article will already know and understand the difference between risk and volatility, but it is always worthwhile going back through the Buffett archives to remind ourselves what he has said on the topic.

It never hurts to revisit old advice and build on the knowledge you already know. Compounding such an essential financial concept is never a waste of time.

Disclosure: The author owns shares in Berkshire Hathaway.

This article first appeared on GuruFocus.