sense and

nonsense
in modern
corporate
finance

Thought # 1: A lot of what youve been

taught is wrong

Example # 1:
The Notion of
Risk in
Academic
Corporate
Finance

William Sharpe,
Noble Laureate

High degree of variability

means high risk

Low degree of variability

means low risk

Inference:
Treasury bonds are risk-free securities
because they have zero variability of return.

Treasury
bonds are
risk free
Hmmm

We define
risk, using
dictionary
terms, as the
possibility of
loss or
injury.

The real risk that an investor must assess is whether his aggregate aftertax receipts from an investment (including those he receives on sale) will
over his prospective holding period, give him at least as much purchasing
power as he had to begin with, plus a modest rate of interest on that initial
stake.

Investing is
often
described as
the process
of laying out
money now in
the
expectation of
receiving
more money in
the future.

At Berkshire we take a more demanding approach, defining investing as the

transfer to others of purchasing power now with the reasoned expectation
of receiving more purchasing power after taxes have been paid on
nominal gains in the future. More succinctly, investing is forgoing
consumption now in order to have the ability to consume more at a later
date.
From 2011 Letter.

If you forego ten

hamburgers to
purchase an
investment;

receive dividends
which, after tax, buy
two hamburgers;

and receive, upon sale of

your holdings, after-tax
proceeds that will buy
eight hamburgers,

then you
have had
no real
income
from your
investment,
no matter
how much
it
appreciated
in dollars.

You may
feel
richer,

but you
wont
eat
richer.

Bonds promoted
as offering riskfree returns
are now priced
to deliver
return-free
risk.
From 2011 Letter
commenting on
the prevailing
almost zero
interest rates on
treasury bonds.

Example # 2:
The Relationship
between Risk
and Return in
Academic
Corporate
Finance

Academic Finances
Definition of Risk

Two components:
Systematic and
Unsystematic risk

Investors will not get paid to assume unsystematic risk because that
component of total risk can be diversified away.

Investors will
get paid only
for taking
systematic
risk, a proxy
of which is
beta.

Academics...like to define investment risk differently, averring that it is

the relative volatility of a stock or portfolio of stocks - that is, their volatility
as compared to that of a large universe of stocks.

High Risk
High Return

Low Risk
Low Return

Stocks with high beta are riskier than stocks

with lower betas but are expected to deliver
higher returns.
Hmmmmm

Stocks with high beta are riskier than stocks with lower betas but are
expected to deliver higher returns.

Do
?

Do stocks with large betas outperform stocks with low betas?

Ans: No

Do

Do stocks with identical beta produce same returns?

Ans: No

Is

a proxy
for

Ans: No
Volatility is not the same as risk.

Beta does not capture risk

How does He
think of Risk?

Though this risk cannot be calculated with engineering precision, it can in

some cases be judged with a degree of accuracy that is useful
The primary factors bearing upon this evaluation are:

A. The
certainty
with which
the long-term
economic
characteristic
s of the
business can
be evaluated

B. The
certainty with
which
management
can be
evaluated,
both as to its
ability to
realize the
full potential
of the business
and to wisely
employ its cash
flows

C. The
certainty with
which
management
can be
counted on to
channel the
rewards from
the business
to the
shareholders
rather than
to itself.

D. The
purchase
price of
the
business

E. The levels
of taxation and
inflation that
will be
experienced and
that will
determine the
degree by which
an investor's
purchasingpower return is
reduced from
his gross
return.

The Trouble
with his
definition of
risk?
You cannot
objectively
measure it!

Is that a problem?

False
precision is
totally
crazy... It
only
happens to
people with
high IQs.

The desire to be PRECISE makes people do some incredibly FOOLISH things.

Its better to
be
approximately
right than to
be precisely
wrong - John
Maynard
keynes

The desire to be PRECISE makes people do some incredibly FOOLISH things.

Not
everything
that counts
can be
counted, and
not everything
that can be
counted,
counts. Einstein

Buffett
on RISK

Extract from 2011 Annual Report of Berkshire Hathaway

The Basic Choices for Investors and the One We Strongly Prefer
Investing is often described as the process of laying out money now in the expectation of receiving more money in the future. At Berkshire we take a more demanding approach, defining
investing as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power after taxes have been paid on nominal gains in the future.
More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date.
From our definition there flows an important corollary: The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in
measuring risk) but rather by the probability the reasoned probability of that investment causing its owner a loss of purchasing-power over his contemplated holding period.
Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. And as we will see, a
non-fluctuating asset can be laden with risk.
Investment possibilities are both many and varied. There are three major categories, however, and its important to understand the characteristics of each. So lets survey the field.
Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are
thought of as safe. In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge.

Buffett
on RISK

Berkshire Hathaways AGM for 1993: Comments on Risk

Shareholder: There appears to be inconsistencies between your view of risk and the conventional view.Derivatives are dangerous. And yet you feel comfortable playing derivatives through Salomon.
Betting on hurricanes is dangerous. And yet you feel comfortable playing with hurricanes through insurance companies. So it appears that you have some view of risk thats inconsistent with what
would appear on the face of it to be conventional view of risk.
Buffett: We do define risk as the possibility of harm or injury. Therefore, we think its inextricably would up in our time horizon for holding an asset. If you intend to buy XYZ Corporation at 11:30 this
morning and sell it out before the close today, thats a very risky transaction in our view -because we think that 50% of the time, youre going to suffer some harm or injury. On the other hand, given a
sufficiently long time horizon . . .
For example, we believe that the risk of buying something like Coca Cola at the price we paid a few years ago is close to nil -given our prospective holding period. But if you asked me to assess the
risk of buying Coca-Cola this morning and selling it tomorrow morning, Id say that thats a very risky transaction.
As I pointed out in the annual report, it became very fashionable in the academic world -and it spilled over into the financial markets -to define risk in terms of volatility of which beta is a measure. But
that is no measure of risk to us.
The risk in terms of our super-cat business is not that we lose money in any given year. We know were going to lose money in some given day. Thats for certain. And were extremely likely to lose
money in some years. But our time horizon in writing that business would be at least a decade. And we think that our probability of losing money over a decade is low. So in terms of our horizon of
investment, we think that it is not a risky business.
And its a whole lot less risky than writing something that is much more predictable. Its interesting to us that using conventional measures of risk, something whose return varies from year-to-year
between +20% and +80% is riskier than something that returns 5% a year every year. We think the financial world has gone haywire in terms of how they measure risk.

Buffett
on RISK

Berkshire Hathaways AGM for 1993: Comments on Risk

Shareholder: Wall Street often evaluates the riskiness of a particular security by the volatility of its quarterly or annual results -and likewise, measures money managers riskiness by
their volatility. I know you guys dont agree with that approach. Could you give us some detail about how you measure risk?
Buffett: We regard volatility as a measure of risk to by nuts. And the reason its used is because the people that are teaching want to talk about risk -and the truth is that they dont know
how to measure it in business. Part of our course on how to value a business would also be on how risky the business is. And we think about that in terms of every business we buy.
Risk with us relates to several possibilities. One is the risk of permanent capital loss. And the other risk is that theres just an inadequate return on the kind of capital we
put in.
However, it doesnt relate to volatility at all. For example, our SeesCandy business will lose money-and it depends on when Easter falls -in two quarters each year. So it has this huge
volatility of earnings within the year. Yet its one of the least risky businesses I know. You can find all kinds of wonderful businesses that have great volatility in results. But that doesnt
make them bad businesses.
Similarly, you can find some terrible businesses with very low volatility. For example, take a business that did nothing. Its results wouldnt vary from quarter to quarter. So it just doesnt
make any sense to equate volatility with risk.
END
Notice he talks about two types of risks: Risk of permanent loss of capital and Opportunity loss.

Buffett
on RISK

Berkshire Hathaways AGM for 1994: Comments on Risk

Buffett: We do define risk as the possibility of harm or injury. Therefore, we think its inextricably wound up in your time horizon for holding an asset. If you intend to buy XYZ Corporation at 11.30 this morning and sell it out before the close today, that
is a very risky transaction in our view because we think that 50% of the time, youre going to suffer some harm or injury. On the other hand, given a sufficiently long time horizon
For example, we believe that the risk of buying something like Coca-Cola at the price we paid a few years ago is close to nil given our prospective holding period. But if you asked me to assess the risk of buying Coca-Cola this morning and selling
it tomorrow morning, Id say that thats a very risky transaction.
Buffett: As I pointed out in the annual report, it became very fashionable in the academic world and it spilled over into the financial markets to define risk in terms of volatility of which beta became a measure. But that is no measure of risk to us.
The risk in terms of our super-cat business is not that we lose money in any given year. We know were going to lose money in some given day. Thats for certain. And were extremely likely to lose money in some years. But our time horizon in
writing that business would be at least a decade. And we think that our probability of losing money over a decade is low. So in terms of our horizon of investment, we think that that is not a risky business.
And its a whole lot less risky than writing something that is much more predictable. Its interesting to us that using conventional measures of risk, something whose return varies from year-to-year between +20% and +80% is riskier as its defined
than something that returns 5% a year every year. We think the financial world has gone haywire in terms of how it measures risk.
Buffett: Were perfectly willing to lose money on a given transaction arbitrage being one example and any given insurance policy being another. But were not willing to enter into any transactions in which we think the probability of a number of
mutually independent events of a similar type has an expectancy of loss.
And we hope that were entering into transactions where our calculations of those probabilities have validity. To do so, we try to narrow it down. There are a whole bunch of things that we just dont do because we dont think we can write the
equation on them.
Basically, Charlie and I are pretty risk-averse by nature. But if we knew it was an honest coin and someone wanted to give us 7-to-5 (odds) or something of the sort on one flip, how much of Berkshires net worth would we put on that flip? It would
sound like a big number to you. It wouldnt be a huge percentage of (Berkshires) net worth, but it would be a significant number. Well do things where the probabilities favor us.

Munger &
Buffett on RISK

Munger: This great emphasis on volatility in corporate finance we regard as nonsense. Let me put it this way. As long as the odds are in our favor and
were not risking the whole company on one throw of the dice or anything close to it, we dont mind volatility in results. What we want are the favorable
odds. We figure the volatility over time will take care of itself at Berkshire.
Buffett: If we have a business about which were extremely confident as to the business results, wed prefer that its stock have high volatility. Well make
more money in a business where we know what the end game will be if it bounces around a lot.
For example, Sees may lose money in eight months in a typical year. However, it makes a fortune in November and December. If it were an independent,
publicly-traded company and people reacted to that and therefore made its stock very volatile, that would be terrific for us. We could buy it in July and sell
it in January because wed know it was nonsense.
Well, obviously, things dont behave quite that way. But when we bought The Washington Post, it had gone down 50% in a few months. Well, that was the
best thing that could have happened. It doesnt get any better than that. Its businesses were fundamentally very non-volatile a strong, dominant
newspaper and TV stations but it was a volatile stock. Thats a great combination in our view.
When we see a business about which were very certain whose fortunes the world thinks are going up and down and so its stock behaves with great
volatility we love it. Thats way better than having a lower beta. We actually prefer what other people call risk.

HOW DOES HE
THINK ABOUT
THE
RELATIONSHIP
BETWEEN
RISK AND
RETURN

If someone were to say

to me, I have here a sixshooter and I have
slipped one cartridge
into itWhy dont you
just spin it and pull it
once? If you survive, I
will give you $1 million.

I would
decline perhaps
stating
that $1
million is
not
enough.

Then he might offer me $5

million to pull the trigger
twice...
Now that would be a positive
correlation between risk
and reward!

The exact opposite is true with

value investing. If you buy a
dollar bill for 60 cents, its
riskier than if you buy a dollar
bill for 40 cents, but the
expectation of reward is greater
in the latter case.

This is one of those ideas that grab you immediately, or you struggle with it
all your life.
For me it grabbed me immediately when I encountered it in Buffetts essay,
The Superinvestors of Graham-and-Doddsville while studying in London.

The greater the

potential for
reward in the
value
portfolio, the
less risk there
is.

Return

Risk

TO MAKE
MONEY
TAKE RISK

TO MAKE
MONEY
SHUN RISK

Tweedy Browne

One of the many unique and advantageous

aspects of value investing is that the larger the
discount from intrinsic value, the greater the
margin of safety and the greater potential
return when the stock price moves back to
intrinsic value... Contrary to the view of
modern portfolio theorists that increased
returns can only be achieved by taking greater
levels of risk, value investing is predicated on
the notion that increased returns are associated
with a greater margin of safety, i.e. lower risk.

All true value investors believe the inverse relationship between risk and return where risk is
defined the way Buffett defines it.

I have never
been able to
figure out
why its
riskier to
buy $400
million
worth of
properties
for $40
million than
$80 million.
The Washington Post Company in 1973 was selling for $80 million in the market. At the time, that day, you could have sold the
assets to any one of ten buyers for not less than $400 million, probably appreciably more. The company owned the Post,
Newsweek, plus several television stations in major markets. Those same properties are worth $2 billion now, so the person who
would have paid $400 million would not have been crazy. Now, if the stock had declined even further to a price that made the
valuation $40 million instead of $80 million, its beta would have been greater. And to people who think beta measures risk, the
cheaper price would have made it look riskier. This is truly Alice in Wonderland. I have never been able to figure out why its
riskier to buy $400 million worth of properties for $40 million than $80 million. And, as a matter of fact, if you buy a group of
such securities and you know anything at all about business valuation, there is essentially no risk in buying ten $40 million piles
for $8 million each.
In assessing risk, a beta purist will disdain examining what a company produces, what its competitors are doing, or how much
borrowed money the business employs. He may even prefer not to know the company's name. What he treasures is the price
history of its stock. In contrast, we'll happily forgo knowing the price history and instead will seek whatever information will
further our understanding of the company's business. After we buy a stock, consequently, we would not be disturbed if markets
closed for a year or two.

Example # 3:
The Capital
Asset Pricing
Model (CAPM)

Employing
databases and
statistical skills,
these academics
compute with
precision the
"beta" of a stock its relative
volatility in the
past - and then
build arcane
investment and
capital-allocation
theories around
this calculation.

In their
hunger for a
single
statistic to
measure risk,
however, they
forget a
fundamental
principle: It
is better to be
approximately
right than
precisely
wrong.

His first critique of

CAPM is that it
uses beta, which is a
flawed measure of
risk.
But there is a
second, terribly
important critique
of CAPM.

To understand that, we need to jump over a jurisdictional boundary of corporate finance into the realm of psychology.

Jumping over jurisdictional

boundaries:
An introduction to
multidisciplinary thinking.

envy

Envy is the only one of the seven deadly sins which gives us nothing. There is NO upside in envy.
Rejecting opportunities that would make you rich because others have better ones is envy.
You will never find the mention of envy in any corporate finance textbook. Does that mean you should ignore
its influence on human decisions simply because the idea belong to another discipline?

How crazy it would be to be made

miserable by the fact that someone
else is doing better because
someone else is always going to be
doing better at any human activity
you can name. - Charlie Munger
What the hell do I care if somebody else makes money faster. Theres always going to be
somebody who is making money faster, running the mile faster or what have you. Once you
get something that works fine in your life, the idea of caring terribly that somebody else is
making money faster strikes me as insane.
If youve got a way of investing your money that is overwhelmingly likely to keep you
comfortably rich and someone else finds something that would make him richer faster, that
is not a big tragedy.

Reject
projects
where
IRR<WACC

Dont be
envious

Lets digress a bit here because I want to talk to you a bit more about
multidisciplinary thinking. We will return to discussion of envy in corporate
finance in a while.
Here is a story in corporate finance illustrating one of the best decisions
made by Warren Buffett in his career.

Physics
envy

Lets return to the subject of envy

B schools aspire to the same standards of

academic excellence that hard disciplines
embracean approach sometimes waggishly
referred to as physics envy.- Warren Bennis

Virtually none of todays top-ranked business schools would hire, let alone promote, a tenure-track professor whose primary
qualification is managing an assembly plant, no matter how distinguished his or her performance. Nor would they hire professors
who write articles only for practitioner reviews, like this one. Instead, the best B schools aspire to the same standards of academic
excellence that hard disciplines embracean approach sometimes waggishly referred to as physics envy.
Business school professors using the scientific approach often begin with data that they use to test a hypothesis by applying such
tools as regression analysis. Instead of entering the world of business, professors set up simulations (hypothetical portfolios of R&D
projects, for instance) to see how people might behave in what amounts to a laboratory experiment. In some instances those methods
are useful, necessary, and enlightening. But because they are at arms length from actual practice, they often fail to reflect the way
business works in real life.
When applied to businessessentially a human activity in which judgments are made with messy, incomplete, and incoherent data
statistical and methodological wizardry can blind rather than illuminate.
http://en.wikipedia.org/wiki/Warren_Bennis

In physics it takes
three laws to
explain 99% of the
data; in finance it
takes more than 99
laws to explain
about 3%.- Andrew
Lo

Watch this video: Warning: Physics Envy May be Hazardous to Your Wealth
http://video.mit.edu/watch/warning-physics-envy-may-be-hazardous-toyour-wealth-9573/

Imagine how
much harder
physics
would be if
electrons
had
feelings!
Richard
Feynman

Why are economists trained so formally? It makes sense to axiomatize a discipline when the axioms are true (or almost so) and have strong
predictive power. Thats the case for euclidean geometry, for example, as well as Maxwells electromagnetic theory, where many valid, useful,
and accurate predictions follow from applying the laws of deduction to a few initial assumptions.
But economists seem to have embraced formality and physics envy without the corresponding benefits of accuracy or predictability. In physics,
Maxwells theory and quantum mechanics allow you to predict the way an electron spins about its own axis inside a hydrogen atom to an
accuracy of twelve decimal places. Something that accurate isnt just a modelits a law. In economics, by contrast, there are no laws at all,
only models, and youre immensely lucky if you can predict up from down...
Clearly, then, when someone shows you an economic or financial model that involves mathematics, you should understand that, despite the
confident appearance of the equations, what lies beneath is a substrate of great simplification andsometimes great and wonderful
imagination. Thats not a bad thingfinancial markets are all about imagination. But you should never forget that even the best financial model
can never be truly valid because, unlike the physical world, the mental world of securities and economics is much less amenable to the power
of mathematics.

h"p://www.emanuelderman.com/media/beware.hbr.pdf

in the stock
market the
more
elaborate and
abstruse the
mathematics
the more
uncertain and
speculative
are the
conclusionsBen Graham
There is a special paradox in the relationship between mathematics and investment
attitudes on common stocks, which is this: Mathematics is ordinarily considered as
producing precise and dependable results; but in the stock market the more elaborate
and abstruse the mathematics the more uncertain and speculative are the conclusions
we draw therefrom. In 44 years of Wall Street experience and study I have never seen
dependable calculations made about common-stock values, or related investment
policies, that went beyond simple arithmetic or the most elementary algebra. Whenever
calculus is brought in, or higher algebra, you could take it as a warning signal that the
operator was trying to substitute theory for experience, and usually also to give to
speculation the deceptive guise of investment.- Ben Graham

Economics should emulate physics

basic ethos, but its search for
precision in physics-like formulas
is almost always wrong.

Buffett
on CAPM

Berkshire Hathaways AGM for 1998

Shareholder: Do you differentiate between types of businesses in your discounted cash flow analysis given that you use the same discount rate across companies? For example, when you value
Coke and GEICO, how do you account for the difference in the riskiness of their respective cash flows?
Buffett: We dont worry about risk in the traditional way for example, in the way youre taught at Wharton. Its a good question, believe me. If we could see the future of every business
perfectly, it wouldnt make any difference to us whether the money came from running street cars or selling software because all of the cash that came out which is all were measuring
between now and Judgement Day would spend the same to us.
Therefore, the industry that earned it means nothing to us except to the extent that it may tell you something about the ability to develop the cash. But it doesnt tell you anything about the
quality of the cash. Once it becomes distributable, all cash is the same.
Buffett: When we look at the future of businesses we look at riskiness as being sort of a go/no-go valve. In other words, if we think that we simply dont know whats going to happen in the
future, that doesnt mean its risky for everyone. It means we dont know that its risky for us. It may not be risky for someone else who understands the business.
However, in that case, we just give up. We dont try to predict those things. We dont say, Well, we dont know whats going to happen. Therefore, well discount some cash flows that we dont
even know at 9% instead of 7%. That is not our way to approach it.
Once it passes a threshold test of being something about which we feel quite certain we tend to apply the same discount factor to everything. And we try to only buy businesses about which
were quite certain.
Buffett: As for the capital asset pricing model type reasoning with its different rates of risk adjusted returns and the like, we tend to think of it well, we dont tend to think of it. We consider, it
nonsense.

Learn to focus on
avoidance of foolish
behavior

Lets return to the examples of how youve been mis-taught (in my view).

Example # 4:
Markets are
Efficient

From William Sharpes book, Investments

If investors did get an extra return (a risk premium) for bearing unsystematic risk... ...it would turn
out that diversified portfolios made up of stocks with large amounts of unsystematic risk would give
larger returns than equally risky portfolios of stocks with less unsystematic risk... Investors would
snap up the chance to have these higher returns, bidding up the prices of stocks with large
unsystematic risks and selling stocks with equivalent betas but lower unsystematic risk... This
process would continue until the prospective returns of stocks with the same betas were equalized
and no risk premium could be obtained for bearing unsystematic risk.. Any other result would be
inconsistent with the existence of an efficient market.
In other words, assume a theory [EMT] is true, then make another theory [CAPM] based on that. Then
say, hey, if something happens that disproves CAPM, that must mean EMT is not true, but because we
KNOW its true, then CAPM must also be true!

There are no
undervalued
or overvalued
securities and
that market
prices are
always
correct.
Price= Value

EMT: Stock prices reflect everything about a companys prospects and the state of the
economy.

Implication: Investors who seem to beat the

market year after year are just lucky

No point
doing any type
of analysis
Price already
reflects all
possible
analysis

Supporting
Argument:
Prices change
quickly in
response to
new
information.
But do price
change
correctly?

or Do markets tend to overreact? Do they

Under-react

Yes. This has been empirically tested several times.

Stock market is a semi-psychotic creature given to extremes of elation and
despair.

Supporting
Argument:
Most
investors
cant beat
the market

But how could

most investors do
better than the
market when they
are the market?

If superior
performance was
caused due to
luck, would not
that performance
revert to the mean
over time?

EMT proponents insist that its not worth looking at the track record of
Buffett, Munger, Walter Schloss, Tweedy Browne, and other super-investors

The proposition
that the market is
rational some of
the time is
different from the
proposition that
the market is
always rational.

The proposition that the market is rational some of the time is different
from the proposition that the market is always rational.

Even a
broken
clock
tells the
correct
time twice
a day
Negative Empericism. We dont have to prove that markets are efficient
We can prove that if they were efficient then some things should not
happen. For example the following should not exist:
1.Cash Bargains
2.Debt-Capacity bargains
3.Over and under reactions
4.Closed-end fund puzzle

Buffett
on EMT

Extract from 1988 Annual Report of Berkshire Hathaway

This doctrine became highly fashionable - indeed, almost holy scripture in academic circles during the 1970s. Essentially, it said that analyzing stocks was useless because all public information about them was appropriately reflected in their prices. In other words,
the market always knew everything. As a corollary, the professors who taught EMT said that someone throwing darts at the stock tables could select a stock portfolio having prospects just as good as one selected by the brightest, most hard-working security
analyst. Amazingly, EMT was embraced not only by academics, but by many investment professionals and corporate managers as well. Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient.
The difference between these propositions is night and day.
In my opinion, the continuous 63-year arbitrage experience of Graham-Newman Corp. Buffett Partnership, and Berkshire illustrates just how foolish EMT is. (Theres plenty of other evidence, also.) While at Graham-Newman, I made a study of its earnings from
arbitrage during the entire 1926-1956 lifespan of the company. Unleveraged returns averaged 20% per year. Starting in 1956, I applied Ben Grahams arbitrage principles, first at Buffett Partnership and then Berkshire. Though Ive not made an exact calculation, I
have done enough work to know that the 1956-1988 returns averaged well over 20%. (Of course, I operated in an environment far more favorable than Bens; he had 1929-1932 to contend with.)
All of the conditions are present that are required for a fair test of portfolio performance: (1) the three organizations traded hundreds of different securities while building this 63- year record; (2) the results are not skewed by a few fortunate experiences; (3) we did
not have to dig for obscure facts or develop keen insights about products or managements - we simply acted on highly-publicized events; and (4) our arbitrage positions were a clearly identified universe - they have not been selected by hindsight.
Over the 63 years, the general market delivered just under a 10% annual return, including dividends. That means $1,000 would have grown to $405,000 if all income had been reinvested. A 20% rate of return, however, would have produced $97 million. That
strikes us as a statistically-significant differential that might, conceivably, arouse ones curiosity.
Yet proponents of the theory have never seemed interested in discordant evidence of this type. True, they dont talk quite as much about their theory today as they used to. But no one, to my knowledge, has ever said he was wrong, no matter how many thousands
of students he has sent forth misinstructed. EMT, moreover, continues to be an integral part of the investment curriculum at major business schools. Apparently, a reluctance to recant, and thereby to demystify the priesthood, is not limited to theologians.
Naturally the disservice done students and gullible investment professionals who have swallowed EMT has been an extraordinary service to us and other followers of Graham. In any sort of a contest - financial, mental, or physical - its an enormous advantage to
have opponents who have been taught that its useless to even try. From a selfish point of view, Grahamites should probably endow chairs to ensure the perpetual teaching of EMT.

Buffett
on EMT

Berkshire Hathaways AGM for 1998

Buffett: The hard-form efficient market theory has been quite helpful to us. If you had a merchant shipping business and all of your competitors believed the world
was flat, youd have a huge edge because they wouldnt take on cargo going to places where they think theyd fall off the earth. So we should be encouraging the
teaching of hard-form efficient market theories at universities.
It amazes me, I think it was Keynes who said, Most economists are most economical about ideas they make the ones they learned in graduate school last a lifetime.
What happens is that you spend years getting your Ph.D. in finance. And (in the process), you learn theories with a lot of mathematics that the average layman cant
do. So you become sort of a high priest. And you wind up with an enormous amount of yourself in terms of your ego and even professional security invested in
those ideas. Therefore, it gets very hard to back off after a given point. And I think that to some extent thats contaminated the teaching of investing in the universities.
Buffett: Ive always found the word anomaly interesting because Columbus was an anomaly. AI suppose at least for awhile. What it means is something the
academicians cant explain. And rather than reexamine their theories, they simply discard any evidence of that sort as anomalous.
On the other hand, Charlie and I believe that when you find information that contradicts your existing beliefs, youve got a special obligation to look at I and quickly
Charlie says that one of the things Darwin did whenever he found anything that contradicted any of his cherished beliefs was that he would write it down immediately
because he knew that the human mind was so conditioned to reject contradictory evidence that unless he put it down in black and white very quickly, his mind would
push it out of existence.

Buffett
on EMT

Extract from 2006 Annual Report of Berkshire Hathaway

Walter did not go to business school, or for that matter, college. His office contained one file cabinet in 1956; the number mushroomed to four by 2002. Walter worked without a secretary, clerk or bookkeeper, his only associate being his son, Edwin, a graduate of the North
Carolina School of the Arts. Walter and Edwin never came within a mile of inside information. Indeed, they used outside information only sparingly, generally selecting securities by certain simple statistical methods Walter learned while working for Ben Graham. When
Walter and Edwin were asked in 1989 by Outstanding Investors Digest, How would you summarize your approach? Edwin replied, We try to buy stocks cheap. So much for Modern Portfolio Theory, technical analysis, macroeconomic thoughts and complex algorithms.
Following a strategy that involved no real risk defined as permanent loss of capital Walter produced results over his 47 partnership years that dramatically surpassed those of the S&P 500. Its particularly noteworthy that he built this record by investing in about 1,000
securities, mostly of a lackluster type. A few big winners did not account for his success. Its safe to say that had millions of investment managers made trades by a) drawing stock names from a hat; b) purchasing these stocks in comparable amounts when Walter made a
purchase; and then c) selling when Walter sold his pick, the luckiest of them would not have come close to equaling his record. There is simply no possibility that what Walter achieved over 47 years was due to chance.
I first publicly discussed Walters remarkable record in 1984. At that time efficient market theory (EMT) was the centerpiece of investment instruction at most major business schools. This theory, as then most commonly taught, held that the price of any stock at any
moment is not demonstrably mispriced, which means that no investor can be expected to over-perform the stock market averages using only publicly-available information (though some will do so by luck). When I talked about Walter 23 years ago, his record forcefully
contradicted this dogma.
And what did members of the academic community do when they were exposed to this new and important evidence? Unfortunately, they reacted in all-too-human fashion: Rather than opening their minds, they closed their eyes. To my knowledge no business school
teaching EMT made any attempt to study Walters performance and what it meant for the schools cherished theory.
Instead, the faculties of the schools went merrily on their way presenting EMT as having the certainty of scripture. Typically, a finance instructor who had the nerve to question EMT had about as much chance of major promotion as Galileo had of being named Pope.
Tens of thousands of students were therefore sent out into life believing that on every day the price of every stock was right (or, more accurately, not demonstrably wrong) and that attempts to evaluate businesses that is, stocks were useless. Walter meanwhile went
on over-performing, his job made easier by the misguided instructions that had been given to those young minds. After all, if you are in the shipping business, its helpful to have all of your potential competitors be taught that the earth is flat.
Maybe it was a good thing for his investors that Walter didnt go to college.

Insanity out of
EMT:
Since price =
value there
are no wealth
effects in IPOs
and stock
buybacks

Example # 5:
The Human
Rationality
Assumption in
Economics

Almost all of traditional economics is based on the notion of the rational

man assumption.

Choose between:
85% chance of winning $100 (the gamble)
or
sure gain of $85 (the sure thing)

Choose between:
85% chance of losing $100 (the gamble)
or
sure loss of $85 (the sure thing)

I am 90% sure that empty 747s weight is

between ____ and ____ tons.

Ans: 177 tons

I am 90% sure that the moons diameter is

between ____ and ____ kilometers.

Ans: 3,476 kms

Converting Confidence Level into a

money bet

Rs 1,000 saved on a Rs 10 lac car is worth MORE than the Rs 1,000 saved
on a Rs 10,000 lamp. Really it is!
After all the Rs 1,000 saving when compared to Rs 10 lacs looks SO MUCH
SMALLER than the Rs 1,000 saving on a Rs 10,000 lamp.

Example # 6:
The Bell Curve
Assumption

In a world described by the bell curve, most values are clustered around the middle. The average value is
also the most common value. Outliers contribute very little statistically. If 100 random people gather in a
room and the world's tallest man walks in, the average height doesn't change much.
But if Bill Gates walks in, the average net worth rises dramatically.

Winner
Takes All

Height follows the bell curve in its distribution. Wealth does not. It follows a L-shaped distribution called
power law where most values are below average and a few far above. In the realm of the power law, rare
and extreme events dominate the action.
If you observe low-probability-high-impact events, then the bell curve is the wrong distribution to
capture that.
In a power law world, outliers matter a lot. In a bell curve world, they dont matter.

Nassim Taleb

Theres a place he calls Mediocristan (Bell Curve). This was where early humans lived. Most
events happened within a narrow range of probabilities within the bell-curve distribution
still taught to statistics students. But we dont live there any more. We live in Extremistan
(power law), where black swans proliferate, winners tend to take all and the rest get nothing.

theres Bill Gates, Steve Jobs and a lot of

software writers living in a garage.

theres Domingo and a thousand opera singers

working in Starbucks.

theres JK Rowling, and a million starving

fiction writers

Winner Takes All

7 SD is once every 3 billion years!

Models based on the bell curve distribution, massively underestimate the
both the probability as well as the impact of of outlier events.

Would you like to jump out of this plane

with this parachute which opens 99% of
the time?

Modern Risk Management Practices

Advocate that you should jump

Modern risk management practices (e.g. VAR) assume that we live in a

world best described by a bell curve where outliers are extremely rare, and
that resulted in management practices that were far more risky than was
previously imagined

What you
really want a
course on
investing is
how to value a
business.
Thats what
the game is
about...

And if you look at whats being taught, I think you see very little of how to
value a business.

And the rest of it is playing around with numbers or Greek symbols of something of
that sort... But that doesnt do you any good. In the end, what you have to decide is
whether youre going to value a business at $400 million, $600 million or $800 million
- and then compare that with the price. Thats what investing is. And I dont know any
other kind of investing to do. And that just isnt taught. And the reason why it isnt
taught is because there arent teachers around who know how to teach it... They dont
know themselves. And since they dont, they teach that nobody knows anything - which
is the efficient market theory. . .

Some of the worst business decisions Ive seen came with detailed analysis.
The higher math was false precision. They do that in business schools,
because theyve got to do something. - 2009 AGM

Buffett
on
Academic
Finance

Extract from 1996 Annual Report of Berkshire Hathaway

To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets. You
may, in fact, be better off knowing nothing of these. That, of course, is not the prevailing view at most business schools, whose finance
curriculum tends to be dominated by such subjects. In our view, though, investment students need only two well-taught courses - How to
Value a Business, and How to Think About Market Prices.

Buffett
on
Academic
Finance

Extract from 2008 Annual Report of Berkshire Hathaway

Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta,
gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind
the symbols. Our advice: Beware of geeks bearing formulas.

Thought # 1: A lot of what youve been

taught is wrong

Example # 1:
The Notion of
Risk in
Academic
Corporate
Finance

Example # 2:
The Relationship
between Risk
and Return in
Academic
Corporate
Finance

Example # 3:
The Capital
Asset Pricing
Model (CAPM)

Example # 4:
Markets are
Efficient

Example # 5:
The Human
Rationality
Assumption in
Economics

Example # 6:
The Bell Curve
Assumption

Thought # 2: While people are

irrational in very predictable ways,
you can work towards becoming
rational

Thats what youll learn in

Behavioral finance module

Thought # 3: You can make money off

people who are irrational

Thats what youll learn in Business

Valuation module

Thank You