Tuesday, May 10, 2011

Wisdoms of Warren Buffett: The Willingness to Walk Away

In his 2010’s letter to shareholders, Warren Buffett discussed the four disciplines that make a sound insurance operation. Many insurers passed the first three. It is the last one that distinguished Buffett from others: the willingness to walk away.

Buffett said:
At bottom, a sound insurance operation requires four disciplines: (1) An understanding of all exposures that might cause a policy to incur losses; (2) A conservative evaluation of the likelihood of any exposure actually causing a loss and the probable cost if it does; (3) The setting of a premium that will deliver a profit, on average, after both prospective loss costs and operating expenses are covered; and (4) The willingness to walk away if the appropriate premium can’t be obtained.

Many insurers pass the first three tests and flunk the fourth. The urgings of Wall Street, pressures from the agency force and brokers, or simply a refusal by a testosterone-driven CEO to accept shrinking volumes has led too many insurers to write business at inadequate prices. “The other guy is doing it so we must as well” spells trouble in any business, but none more so than insurance.
As simple as that.

What Buffett said applies not only to insurance. It applies to all businesses, to investment as well, because investment is a business. Like insurers, many investors cannot resist the urge to put money to work. It is always a sad thing when the market is in rally mode but an investor is not a part of the game. “The other guy is doing it” is an often cited excuse. And I’ve heard a better one.

When confronted, many investors would say that Buffett can walk away because he’s so wealthy. He can afford to miss a couple of opportunities. But I am not Buffett. I couldn’t afford to miss any. What if this is once-in-a-life-time and I missed?!

If we put their reasoning together with their often unpleasant returns --- if there is any --- the logic is funny because literally they are saying: I’m poor, so I can afford the risk to be poorer. Forgive me if this sounds harsh. But I know many people, such as gamblers, subscribe to this logic.

Back to their logic, I’d like to point out that it is actually the other way around: Buffett is wealthy because he is willing to walk away. It is not that he is willing to walk away because he is wealthy.

Look at Buffett’s spectacular investment returns (on page 2 of his 2010 letter) and ask, if he risked $1,000 in 1965, how much would that $1,000 worth today. The math is simple. Buffett’s compounded annual gain is 20.2% as listed on the same page. In 45 years, $1,000 will grow to about $4 million at that rate. If Buffett didn’t do a good job to walk away, he will not become the legend.

I would like to suggest everyone memorizing the number. Whenever you want to put $1,000 to work and think you can afford to risk that $1,000, ask yourself, could you really afford to risk $4 million in 45 years?

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Finally I started reading Buffett’s letters. I would like to do it slowly so the content would have time to settle in my mind. I’ll share my progress here. Raise your voice if any of my comments is inappropriate.

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