In his 2011 letter to shareholders, Warren Buffett explained the choices that he sees as available to investors.
Currency denominated investments
These are investments denominated in a given currency, such as bank deposits, cash funds, mortgages and which are supposedly safe. These investments are not risk free because their value can be eroded by inflation, government policy and the actions of speculators.
Investments dependent on the intentions of others
These are assets that are not productive and where an increase in value depends upon somebody else buying the asset at a higher price, such as tulips during the great Tulip Bubble or technological stocks during the buying frenzy of the Dot-Com boom. The risk here is that price rises depend upon an ever increasing pool of speculators. Gold falls within this category even though it is productive in the sense that it has industrial use but industrial demand for gold is limited and secondary to its use as a holding asset.
Investments in productive assets
Assets that are productive – businesses, farms, mines etc – and these are the best assets to hold so long as you only buy them on sound investment principles. “Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment.” -Warren Buffett
The risk in risk-free investments
There is no prize for guessing what type of investment appeals to Buffett. What is interesting here is not so much that Buffett considers the third type of investment to be preferable, but that he attributes a risk factor to an investment of the first category that many would consider to be almost risk free - bank deposits, and by implication, government bonds.
If you asked the average uninformed investor whether a bond issued by a reliable government, or a government guaranteed bank deposit, was risk free, most would agree. Not so, says Buffett. There is the risk of losing capital, possibly smaller than with other investments, but still a risk: bonds are subject to market speculation, for example, or the real value of the investment may fall if the rate of return is less than the rate of inflation.
There is also the risk of opportunity cost. By investing in one of these ”risk-free investments”, an investor risks losing the opportunity of a better return elsewhere. As Charlie Munger has said:
Intelligent people make decisions based on opportunity costs - in other words, it’s your alternatives that matter.
Buffett has said, on occasions, that cash is a lousy investment, such as in this interview with CNBC:
Bufffett and Munger are, of course, not ordinary investors and their aversion to holding cash or investments of the first category, is not necessary applicable to us poorer folk. Buffett’s attitude towards risk and investment is well known:
Be greedy when others are fearful and fearful when others are greedy.
This may be true and Buffett’s track record shows that it works. We can also accept as truth what he says about the risks that we take in investing in currency denoninated assets. But, as lesser mortals, most of us find comfort in having some of our capital in easy-to-liquidate, low risk investments. We do not have the access to funds that Buffett and Munger do, nor are we as financial comfortable as they are.
Most of us are likely to fear loss rather than enjoy the prospect of gain, an aspect of prospect theory, by Noble Prize winning economist Daniel Kahneman and Amos Tversky, that proposes that people value risk and gain in different ways.
Note: As at 30 September 2012, Berkshire Hathaway was holding nearly $42 billion dollars in cash and cash equivalents, up $8 billion from December 2011, so Buffett is either thinking that these currency denominated assets represent a safer bet in the current economy or he is looking around for something to buy. He told CNBC in November 2012 that a couple of multi-billion dollar acquisitions had fallen through and that he was ”salivating” for a big business to buy.