Key Takeaways
- A steep price drop in a company’s stock can signal both a buying prospect and a potential red flag.
- Cheap stocks can be risky stocks, as companies with very low share prices often have worse finances, making it harder for them to bounce back.
Warren Buffett is famous for saying that risk isn’t always volatility—it’s the possibility of permanent loss. In a letter to shareholders, he offered a compelling corollary: when a stock’s price has dropped sharply, it doesn’t always signal a value—it may also indicate the stock has become riskier than before.
His observation flips a common investor intuition on its head: if a stock is “on sale,” shouldn’t it be safer? According to Buffett, a bargain that looks cheap might actually carry hidden dangers that weren’t clearer at a higher price.
How Buffett Measures Risk
Academics often define risk mathematically, using a stock’s “beta,” which measures how much a stock’s price moves compared with the broader stock market. Under the mainstream framework, a stock that plunges appears riskier on paper precisely because its price has fluctuated more than that of the S&P 500 index.
Buffett called that view “precisely wrong.” His point, as a value investor, is that when certain shares are offered at a fraction of their previous value, the lower price can make it a better deal. “Price is what you pay; value is what you get… I like buying quality merchandise when it is marked down.” In other words, if intrinsic value hasn’t much changed, a lower price widens your margin for safety.
But, he also warned, not every sharp decline signals a bargain. Sometimes, the lower price reflects serious, permanent problems—shrinking profits or a company that is too deeply in debt to recover. That’s why a stock that’s suddenly dropped in price can increase risk: it may reveal problems with management, competitive pressures, or a balance sheet with too much borrowing to withstand bad times. In those cases, lower isn’t safer; it’s a red flag.
While it might seem contradictory, Buffett’s stance is consistent: he views risk as tied to the actual qualities of a business and its intrinsic value more than to market gyrations. The lower the price relative to value, the less room for error you have.
How a Sharp Decline Increases Risk
Buffett is not saying falling prices are always risky. But they can become dangerous in at least three situations:
- When companies are in financial trouble, as a business comes under intense pressure, its profits and future income are put into question. If earnings fall, debts become harder to pay off, and the company has less wiggle room. In that scenario, stockholders are last in line to get paid. That means, if things go badly, they lose the most. At low stock prices, there’s often little cushion left, and stockholders are more exposed to the company going bankrupt or needing major restructuring.
- When stocks become hard to sell: Cheap stocks tend to attract less interest—that’s why the price is dropping. The buyer base thins. The spread between buyers’ offers and what sellers want widens. Exiting a position can become harder without pushing the price down even more. A further drop might cascade, especially in illiquid conditions—that is, when few people are trading the stock. Thus, the liquidity “risk premium” rises when prices are depressed, which means you might be stuck holding the stock or have to accept a price that is too low.
- Negative feedback loops: Once a stock falls sharply, it can enter a self-reinforcing loop. Weaker investor confidence leads to them demanding higher returns to take on the risk, which in turn leads to even more selling, resulting in a lower valuation. In that environment, a company that might have been “safe enough” at a higher price can get punished severely when revalued under more demanding investor expectations.
Tip
The cheapest shares in the market—so-called “penny stocks”—are often the riskiest of all. Their ultra-low prices mask fragile business models, thin liquidity, and are frequently the target of fraudsters. They serve as a textbook reminder that “cheaper” does not automatically mean “safer.”
The Bottom Line
Buffett’s line about a stock becoming “riskier” at a lower price is a critique of academic views, not a celebration of falling knives. Price declines can reduce risk when the underlying business is still strong and the investor isn’t using borrowed money, is patient, and thinks like an owner. But low prices increase risk when debt and deteriorating economics convert a temporary markdown into a permanent loss of your money.
For long‑term investors, the task is to judge value, keep cash on hand, and use volatility as an ally—not to let a statistical measure define risk for you.
