Hello Mr. Voss,

I believe Warren Buffett, when compared to Modern Portfolio Theory, looks at risk in a very different light. I think he does not look at asset price volatility as risk at all. No. Price volatility is something that creates opportunity.

Opportunity to buy more (when prices fall) and sell (in case prices rise too much above intrinsic value and there are better opportunities available). No, he thinks of risk in terms of any future event that would lead to a deterioration in the fundamentals of the business so that the earning (or cash generating ability) of the business falls permanently to levels that the price paid is no longer justified. Please, correct me if i am mistaken but this is, in my humble opinion, what he means by ''permanent capital loss''.

I agree with you completely that business people are able to understand, anticipate and mitigate risk by understanding the underlying business dynamics. This is exactly what Mr. Buffett does best. He has studied certain businesses/industries (which he likes to call his circle of competence) over the decades to the point that he understands factors driving business and eventually stock performance quite well. (And yes there is a difference between the underlying business and the stock although the performance of both is mostly positively correlated in the long run but not necessarily in the short run.)

The argument that stock performance is not correlated to the underlying business performance can be put to rest for good with this question:

''What would happen to the price of the stock if Coca-Cola stopped selling it's drinks and other products?'' (Sales is a business fundamental.)

The answer is undoubtedly;

''The price would go down to zero and the company is likely to be liquidated.''

So, if price volatility is not a measure of risk and it is important to understand the underlying business then what happens if Mr Buffett is unable to comfortably predict the future cash flows of a business operation? How does he value such a business?

The answer to this is quite simple; '' He doesn't.'' Yes, you read correctly. He does not invest in businesses for which he is unable to forecast the cash flows. Hard to believe it's that simple? I thought so too the first time I read this in one of Berkshire Hathaway's annual letters to the shareholders. But this makes perfect sense if we consider what he has always stated regarding his circle of competence. That is ''do not invest in anything you don't understand.''
He is perfectly happy walking away from a deal he is unsure of.

The question comes up if Mr. Buffett does not take asset price volatility or Beta (price volatility of a stock in relation to the market) as risk/measure of risk then how does he come up with the required rate of return?

I am currently researching this very question and have not come up with a definite answer as yet but I think that he probably uses the build up method of some sort to come up with a specific required rate of return. The required rate of return would have to be the same for all assets. I know this is hard to digest especially for people who have always considered price volatility or Beta as a measure of risk but it makes perfect sense. I have heard a few people, who are close to, Mr. Buffett say that he uses a 15% return on all of his investments.

Another risk mitigation method is the use of the concept of ''Margin of Safety'' where Mr Buffett calculates the value of a stock and then discounts one third of the value to come up with an even more conservative method. This is his buffer in case things don't turn out the way he had anticipated and his losses would be mitigated even more. It's all simple to understand but not easy to implement.

Thank you so much for taking out the time to read my comment.

Regards.

Muhammad.