Warren Buffett David A. Grogan | CNBC

Warren Buffett long ago provided a piece of investing advice that could have helped investors in the most recent stock whipsaw. Fears just a few weeks ago that Turkey would crash the global economy were followed up in the past two trading sessions by new records being set in the Dow, and Nasdaq. How is that possible? The answer from the billionaire investor, provided over the years at Berkshire Hathaway annual meetings, is straightforward, and it is nothing revolutionary. But for investors new to stocks since the Great Recession and only familiar with a bull market, it can help to understand why panicking over day-to-day volatility in stocks is counter-productive. Every time volatility spikes it is important to remember that the stock market does not exist to instruct investors; it is there to serve them. Put another way: Market volatility is a bad measure of investor risk.

A trader on the floor of the New York Stock Exchange the morning after the Dow Jones Industrial Average dropped over 1,000 points on Feb. 9, 2018. Spencer Platt | Getty Images News | Getty Images

There have been plenty of specific stock market triggers in 2018, a year in which volatility has returned to stocks after abnormally low levels. Trump's trade war, Federal Reserve policy and emerging markets struggles all have played a role in recent stock volatility. A trade deal with Mexico to replace NAFTA on Monday was the most recent example. But Buffett's point is that investors should not look to stock market volatility as a measure of their own risk. In 1997, the billionaire investor made a clear distinction between the way to think about stock markets and businesses, invoking the approach of his idol, the famous value investor Benjamin Graham. The key of the Graham approach to investing is not thinking of stocks as part of a stock market but as individual businesses. If the business does well then the investor will also do well, as long as they haven't paid too much for it.



"The stock market is there to serve you and not instruct you. That is the key to owning a good business and getting rid of the risk that would otherwise exist," Buffett told investors in 1997, a year that saw the Asian currency crisis lead to investor panic. "Volatility doesn't matter ... if volatility averages half a percent a day or a quarter of a percent or five percent ... we would make more money if volatility is higher because it would create more mistakes. Volatility is a huge plus to real investors." In 2003, after a period of years that saw the dotcom bubble crash and Sept. 11, Buffett again reminded investors that the market's role is to serve, not instruct, and remarked that it is "almost impossible to do well in equities over time if you go to bed every night thinking about the price of them." He added, "Focusing on the price of a stock is dynamite. It really means you think the market knows more than you do."

Why Buffett's advice may fail index fund investors when they most need it

Buffett's reasoning is supported by a dismissive view of volatility that he provided at another rocky time for the markets, 2007: "It's nonsense," he said. "Volatility does not determine the risk of investing." What does determine risk? Again, it is the actual business. "Risk comes from the nature of certain kinds of businesses. It can be risky to be in some businesses just by the simple economics of the type of business you're in, and it comes from not knowing what you're doing. ... If you understand the economics of the business in which you are engaged, and you know the people with whom you're doing business, and you know the price you pay is sensible, you don't run any real risk."

It is fair to say that understanding of actual businesses failed Buffett in 2007 as the financial crisis was caused by risks in a sector he knows as well as anyone, financial services — he claimed afterwards in Congressional testimony that no one could see coming. But it also led him to make very profitable investments in financial companies after their prices plummeted. Regardless, the message here is not for billionaire investors, and there is a more important reason it can be an even harder one for the average investor to take.

Volatility does not determine the risk of investing. Warren Buffett