Does Buffett Know Something We Don't?

In a previous article, I explained why Millennials shouldn’t take Warren Buffet’s investment advice literally. I argued that the Millennials face real economic hurdles (which I call the Millennial Disadvantage) and that, with the chance of a prolonged environment of reduced average equity returns and increase volatility, it might not be best for our generation to be married to the broader market.

One thing I haven’t yet touched on is Buffett’s suggestion that, if interest rates remain low, individuals should continue to invest in the stock market.

“We are not in bubble territory or anything of the sort… Measured against interest rates, stocks are actually on the cheap side” Buffett told CNBC a few weeks back.

Many investors took this comment literally and are wondering if Buffett either knows something others don’t (which is highly possible) or is turning a blind eye to the current market environment and his previous teachings that so many investors hold in high regard.

It’s difficult to argue that stocks today are trading at attractive prices. The most common way to value the market is to compare the price of a broad index like the S&P 500 to its average earnings over the past ten years (known as the CAPE) . By that metric, the S&P 500 is trading at its most expensive since the dot-com bubble.

But the extended period of low interest rates have reduced the attractiveness of investments of lesser risk like bonds and utilities so, at the most basic level, Buffett is arguing that the stock market is one of the only options individual investors have for preserving (and hopefully accumulating) wealth.

But the thing that perplexes me about Buffett’s advice is that he’s often noted the importance of price. While he first looks for quality companies, he ensures he invests at a bargain price.

See, for investors that follow the principles of Modern Portfolio Theory, price in and of itself is not a risk — only the movement of price up and down, i.e., an investment’s volatility.

Buffett’s perspective is the exact opposite. In his view, volatility is only a risk if you have a short-term time frame (which Buffett doesn’t); otherwise, it is an opportunity. Price, on the other hand, is at the very heart of risk.

For Buffett, price and risk are inseparable. While high risk may often come from high prices, low prices, on the other hand, can potentially reduce risk and dramatically increase your chances of high returns.

The central question for Buffett is always what the price of an asset is in relation to its underlying value.

If price exceeds or is even comparable to that value, the investment is risky, regardless of its volatility. High prices increase the likelihood of sub-par returns; the law of reversion to the mean suggests that high-flying stocks will eventually come back to earth. And if that high price reflects an excess of enthusiasm in the market and, possibly, a bubble waiting to burst, it also carries the possibility of a significant and possibly permanent loss of capital.

This is where Buffett’s emphasis on uncertainty comes into play. Good investors know that there are things they don’t (and can’t) know.

Multiple variables that can bring down a stock or the market as a whole are beyond the individual investor’s control and forecasting ability. Understanding and respecting that uncertainty, Buffett insists (in all but the most conservative investments) on a margin of safety that is the difference between a stock’s underlying value and its current market price. This margin of safety only exists when equities are trading at a discounted price. It represents an alternative to the traditional equity reward premium — one that rejects the assumption that greater reward necessarily involves accepting greater risk. The higher the price, the more uncertainty and the greater chance of loss. So, in today’s market environment, when it’s difficult to make a case for an attractive market valuation (or that economic growth will be greater than it’s been historically), investors should reconsider if they should be fully invested in the stock market.