Warren Buffett; Carol Loomis
December 10, 2001
(FORTUNE Magazine) – Two years ago, following a July 1999 speech by Warren Buffett, chairman of Berkshire Hathaway, on the stock market–a rare subject for him to discuss publicly–FORTUNE ran what he had to say under the title “Mr. Buffett on the Stock Market” (Nov. 22, 1999). His main points then concerned two consecutive and amazing periods that American investors had experienced, and his belief that returns from stocks were due to fall dramatically. Since the Dow Jones Industrial Average was 11194 when he gave his speech and recently was about 9900, no one yet has the goods to argue with him.
So where do we stand now–with the stock market seeming to reflect a dismal profit outlook, an unfamiliar war, and rattled consumer confidence? Who better to supply perspective on that question than Buffett?

In this month’s blog, we provide you with a framework. A framework that has been proven since the early 1980s. The ideas were developed by Ron Dembo and is explained and illustrated in his book “Seeing Tomorrow”. Dr. Dembo is the founder of Algorthmics Inc. His former company provides risk management software to the biggest banks, insurance companies and other financial companies.

This framework was developed primarily for making large financial decisions but it can be applied to any decision.

The framework is best explained through a way of an example. We will use the Afterword example in Seeing Tomorrow.

In this example one of the authors was faced with the decision to keep his house or sell it. He was to be posted abroad for a work for three years. Realizing that the rent received would be less than the mortgage payments the author decided to sell his house. As it turns out his decision turned out to be disastrous. Property values increase 70% and the author was priced out of the market to re-enter.

His family and friends urged him to keep the house but he decided to sell the house based on the following reasoning:
• He would not be able to cover the mortgage with the rent payments
• House prices had stabilized and he did not foresee house prices going up or down

At first his decision seemed to be correct. In fact it turned out to be correct for 18 months. Nothing did happen to house prices in the particular area where the author lived. However after two years, the area was in great demand due to middle class families chasing large house where state schools existed and house prices rose by 70% due to the limited supply.

Could have the author foreseen this demand? Perhaps, if the demographics were analyzed. But in most likelihood no one could have seen this coming.

But if he would have being aware of Dr. Dembo’s forward looking risk adjusted framework he would have most certainly made the decision to keep the house and as a result would have reaped the 70% increase in his home. He could have made the following analysis:

1. The Benchmark (point of comparison) against which the decision should have been made was owning a house in the current neighborhood, not the difference in payments between the rent and mortgage
2. The Time Horizon he was working with was not the immediate future or months. But the time he would decide to go back. So the correct time frame to consider would have been the three years to be posted abroad.
3. Rather than focusing just on one Scenario, that prices where going nowhere He ought to have considered other scenarios. Yes, house prices had stabilized. But what if they went up. His failure to consider all scenarios cost him
4. Finally, he needed to Measure the Risk. Had he been aware of the risk-adjusted way to measure risk of Upside minus Risk-adjusted Regret he would have realized that difference in rent payments to pay the mortgage was not the true regret but the true regret was that of not being able to buy back into the market.

We hope this helps you make better decisions in 2012. Happy New Year!

Read Men’s Health: Permanent Vacation–How to quit your job

“I’ve met thousands of successful men on these cruises, and most of them have one thing in common: They’re entrepreneurs.” MH

“Whether you’re the captain of your ship or just one of the crew, your future isn’t about luck; it’s about today’s sweat.” MH

I especially liked the bit on being able to take anyone and making them a doctor in 3 weeks.  Why not?