Warren Buffett's Risk Management Lessons

Warren Buffett's Berkshire Hathaway 2001 and 2002 annual reports outline his risk management framework as follows:

• Accept only those risks you understand. (This requires guarding against the twin biases of overconfidence and the illusion of control.)
• Focus on impact not probability: Do not accept any single or group of risks which threaten solvency no matter how improbable. This requires a comparison of risk appetite to capital. Keep in mind risk is based not only on the experience of what has happened, but also on beyond the data exposures.
• Derivatives are dangerous because they create the incentive to cheat: They are opaque and imbedded with latent and potentially lethal dangers. Since their true nature does not manifest itself until later, track records are of little use. Thus, it becomes difficult to determine cheaters.
• Governance: Berkshire has a small number of interested, component directors who eat their own cooking.[*] They have a clearly stated risk appetite: $6 billion as of 2007 based on $120 billion shareholders’ equity and are willing to sacrifice market share to stay within their risk appetite.