The video explores the unique perspective on risk management and financial prudence held by Warren Buffett and Charlie Munger. They express skepticism about relying solely on statistical probabilities and sigma-based risk calculations due to their observed shortcomings. For these seasoned investors, the focus is on worst-case scenario planning and implementing a significant margin of safety, rather than defining a 'magic number' for financial robustness based purely on theoretical models.

Buffett and Munger highlight their approach of always considering what could go wrong with their investments, instilling excessive conservatism into their financial strategies. The video details historical events like the 1901 Northern Pacific stock incident, emphasizing the inadequacy of sole reliance on mathematical models to predict rare or catastrophic financial events. Their philosophy centers on retaining the capital they have, ensuring they never risk what they can’t afford to lose.

Main takeaways from the video:

Please remember to turn on the CC button to view the subtitles.

Key Vocabularies and Common Phrases:

1. sigma [ˈsɪɡmə] - (noun) - A measure used in statistics to express the standard deviation and variability of a data set. - Synonyms: (standard deviation, variability measure, statistical measure)

We saw a lot of problems develop in an organization that expressed their risks in sigma, and we even argued sometimes with the appropriateness of how they calculated their risk.

2. margin of safety [ˈmɑːrdʒɪn əv ˈseɪfti] - (noun phrase) - A principle of investing in which an investor only purchases securities when their market price is significantly below their intrinsic value. - Synonyms: (safety buffer, financial buffer, protective margin)

We think about worst cases all the time, and then we add on a big margin of safety.

3. gaussian curve [ˈgaʊsiən kɜːrv] - (noun phrase) - A bell-shaped curve that is used in statistics to represent the distribution of a set of data and shows the expected spread around a mean value. - Synonyms: (normal distribution, normal curve, bell curve)

They now have taken the gaussian curve, and they've just changed it away.

4. excessively conservative [ɪkˈsɛsɪvli kənˈsɜːrvətɪv] - (adjective phrase) - Overly cautious with regard to risk-taking and finance. - Synonyms: (overly cautious, risk-averse, prudently restrained)

Berkshire, your returns in 99 years out of 100 will probably be penalized by us being excessively conservative.

5. fat tails [fæt teɪlz] - (noun phrase) - The notion in statistical distributions where rare events are more notable compared to the normal distribution. - Synonyms: (heavy tails, thick tails, abnormal distribution ends)

They talk about fat tails, but they still don't know how fat to make them.

6. margin call [ˈmɑːrdʒɪn kɔːl] - (noun phrase) - A demand by a broker to an investor to deposit further cash or securities to cover possible losses. - Synonyms: (broker call, financial request, investment demand)

And there was a little item at the top of that paper, which we still have at the office, where a brewer in Troy, New York committed suicide by diving into a vat of hot beer because he'd gotten a margin call

7. historical financial events [hɪˈstɔːrɪkəl faɪˈnænʃəl ɪˈvɛnts] - (noun phrase) - Important occurrences in financial markets that provide insight into market behavior and principles. - Synonyms: (market history, financial precedents, fiscal occurrences)

And I've never wanted to end up in a vat of hot beer or so. Those seven days that I put up on the wall. Life in financial markets has got no relation to sigmas.

8. risk management [rɪsk ˈmænɪdʒmənt] - (noun) - The process of identification, assessment, and prioritization of risks followed by coordinated efforts to minimize or control the impact of unfortunate events. - Synonyms: (risk control, risk assessment, risk mitigation)

And now it has gone away again. As I said earlier, the business schools have improved. So has risk control on Wall street.

9. financial robustness [faɪˈnænʃəl roʊˈbʌstnəs] - (noun phrase) - The strength and stability of finances, especially in an unpredictable environment. - Synonyms: (financial stability, economic strength, fiscal resilience)

...rather than defining a 'magic number' for financial robustness based purely on theoretical models.

10. false confidence [fɔːls ˈkɒnfɪdəns] - (noun phrase) - An unrealistic belief in one's ability or outcome based on potentially flawed or biased information. - Synonyms: (overconfidence, misplaced confidence, unfounded assurance)

It's created a lot of false confidence.

Warren Buffett - Why Smart People Become Poor (How We Avoid It)

Can you please elaborate your views on risk? You clearly aren't a fan of relying on statistical probabilities, and you highlight the need for $20 billion in cash to feel comfortable. Why is that the magic number? And has it changed over time? Yeah, well, it isn't the magic number, and there is no magic number. I would get very worried about somebody that walked in every morning and told us precisely how many dollars of cash we needed to be, you know, secure to three sigma or something like that.

Charlie and I have had a lot of. We saw a lot of problems develop in an organization that expressed their risks in sigma, and we even argued sometimes with the appropriateness of how they calculated their risk. And they. It was truly horrible. Yeah, and they were a lot smarter than we were. That's what's depressing.

But we both have the same bent of mind whereby we think about worst cases all the time, and then we add on a big margin of safety, and we don't want to go back to go. I mean, I enjoy tossing those papers in the other room, but I don't want to do it for a living again. So we undoubtedly build in layers of safety that others might regard as foolish. But we've got 600,000 shareholders and we've got members of my family that have 80 or 90% of their net worth in the company. And I'm just not interested in explaining to them that we went broke because there was a 100th of 1% chance that we would go broke.

And there was a. The remaining probability was filled by the chance of doubling our money. And I decided that that was just a good gamble to take. We're not going to do that. It doesn't mean that much. We are never going to risk what we have and need for what we don't have and don't need. We'll still find things to do where we can make money, but we don't have to stretch to do it as my job. And Charlie thinks the same way. I mean, we don't have to talk about it much, but it's our job to figure out what can really go wrong with this place. And we've seen September 11, and we've seen September of 2008, and we'll see other things of a different nature, similar impact in the future.

And we not only want to sleep well of those nights, we want to be thinking about things to do with some excess money we might have around. So it is, if you're calibrating it in some mathematical way, I would say it's really dangerous. I could give you a couple of examples on that, but unfortunately I've learned about them confidential basis. But some really great organizations have had dozens of people with advanced mathematical training and thinking about it daily, making computations, and they don't really get at the problem.

So it's at the top of the mind, always around. Berkshire, your returns in 99 years out of 100 will probably be penalized by us being excessively conservative, and one year out of 100 will survive when some other people won't. Charlie. Yeah, but how do these super smart people with all these degrees and higher mathematics end up doing these dumb things? I think it's explainable by the old proverb that to a man with a hammer, every problem looks pretty much like a nail.

They've learned these techniques and they just twist the problem so they fit the solution, which is not the way to do it, and they have a lack of understanding of history. I would say that one of the things, in 1962, when I set up our office at Keyword Plaza, where we still are, it's a different floor, I put seven items on the wall. Our art budget was $7, and I went down to the library, and for a dollar each I made photocopies of the pages from financial history.

And one of those cases, for example, was in May of 1901, when the northern Pacific corner occurred to. It's kind of interesting in terms of being in Omaha because Herriman was trying to get control of the northern Pacific and James J. Hill was trying to control the northern Pacific. And unbeknownst to each other, they both bought more than 50% of the stock. Now, when two people buy more than 50% of the stock each and they both really want it, they're not just going to resell it.

Interesting things happen to the shorts. And in that paper of May 1901, the whole rest of the market was totally collapsing because northern Pacific went from $170 a share to $1,000 a share in one day trading for cash because the shorts needed it. And there was a little item at the top of that paper, which we still have at the office, where a brewer in Troy, New York committed suicide by diving into a vat of hot beer because he'd gotten a margin call.

And to me, the lesson, that fellow probably understood sigmas and everything and knew how impossible it was that in one day a stock could go from 170 to 1000 and cause margin calls on everything else, and he ended up in a vat of hot beer. And I've never wanted to end up in a vat of hot beer or so. Those seven days that I put up on the wall. Life in financial markets has got no relation to sigmas.

I mean, if everybody that operated in financial markets had never had any concept of standard errors and so on, they would be a lot better off. Don't you think so, Charlie? Well, sure. Here, have some fudge. It's credited a lot of false confidence. And now it has gone away again. As I said earlier, the business schools have improved. So has risk control on Wall street.

They now have taken the gaussian curve, and they've just changed it away. They threw it away. Well, they put just in a different shape than Gauss did, and it's a better curve now, even though it's less precise. They talk about fat tails, but they still don't know how fat to make them. I have no idea. Well, but they knew that. They learned through painful things. They weren't fat enough. They learned the other was wrong, but they don't know what's right. But we always knew that there were fat tails. Warren and I at the Solomon meetings would look over at one another and roll our eyes when the risk control people were talking.

Finance, Investment, Leadership, Risk Management, Conservative Strategy, Historical Events, Warren Buffett, Invest : Repeat