Warren Buffett’s investment advice is timeless. By keeping Buffett’s investment advice in mind, investors can sidestep some of the common traps that damage returns and jeopardize financial goals. The article will elucidate on the vital pillars involved in investing.
1. Invest in what you know…and nothing more
One of the easiest ways to make an avoidable mistake is getting involved in investments that are overly complex. Many of us have spent our entire careers working in no more than a handful of different industries. We probably have a reasonably strong grasp on how these particular markets work and who the best companies are in the space. However, the far majority of publicly-traded companies participate in industries we have little to no direct experience in.
“Never invest in a business you cannot understand.” – Warren Buffett
This doesn’t mean we can’t invest capital in these areas of the market but we should approach with caution. There are too many fish in the sea to get hung up on studying a company or industry that is just too hard to understand. That is why Buffett has historically avoided investing in the technology sector (aside from his purchase of IBM). Peter Lynch once said, “Never invest in an idea you can’t illustrate with a crayon.” Many mistakes can be avoided by staying within our circle of competence and picking up a Crayola.
2. Never compromise on business quality
While saying “no” to complicated businesses and industries is fairly straightforward, identifying high-quality businesses is much more challenging. Buffett’s investment philosophy has evolved over the last 50 years to focus almost exclusively on buying high-quality companies with promising long-term opportunities for continued growth. Some investors might be surprised to learn that the name Berkshire Hathaway comes from one of Buffett’s worst investments.
Berkshire was in the textile manufacturing industry and Buffett was enticed to buy the business because the price looked cheap. He believed that if you bought a stock at a sufficiently low price, there will usually be some unexpected good news that gives you a chance to unload the position at a decent profit – even if the long-term performance of the business remains terrible.
With more years of experience under his belt, Buffett changed his stance on “cigar butt” investing. He said that unless you are a liquidator, that kind of approach to buying businesses is foolish. The original “bargain” price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces. These types of companies also usually earn low returns, further eroding the initial investment’s value. These insights led Buffett to coin the following well-known quote:
“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
One of the most important financial ratios that can be used to gauge business quality is return on invested capital. Companies that earn high returns on the capital tied up in their business have the potential to compound their earnings faster than lower-returning businesses. As a result, the intrinsic value of these enterprises rises over time.
“Time is the friend of the wonderful business, the enemy of the mediocre.”
3. When you buy a stock, plan to hold it forever
Once a high-quality business has been purchased at a reasonable price, how long should it be held?
“If you aren’t thinking about owning a stock for 10 years, don’t even think about owning it for 10 minutes.”
“Our favourite holding period is forever.”
“If the job has been correctly done when a common stock is purchased, the time to sell is almost never.”
Buffett clearly embraces a buy-and-hold mentality. He has held some of his positions for a number of decades. Why? For one thing, it’s hard to find excellent businesses that continue to have a bright long-term future (Buffett runs a concentrated portfolio for this reason). Furthermore, quality businesses earn high returns and increase in value over time. Just like Warren Buffett said, time is the friend of the wonderful business. Fundamentals can take years to impact a stock’s price and only patient investors are rewarded. Finally, trading activity is the enemy of investment returns. Constantly buying and selling stocks eats away at returns in the form of taxes and trading commissions. Instead, we are generally better off to “buy right and sit tight.”
“The stock market is designed to transfer money from the active to the patient.”
4. Diversification can be dangerous
I previously wrote a piece about how to build a dividend portfolio and touched on the topic of diversification. In my view, individual investors gain most of the benefits of diversification when they own between 20 and 40 stocks across a number of different industries. However, many mutual funds own 100s of stocks in a portfolio. Buffett is the exact opposite. Back in 1960, Buffett’s largest position was a whopping 35 percent of his entire portfolio! Simply put, Buffett invests with conviction behind his best ideas and realizes that the market rarely offers up great companies at reasonable prices.
According to him, major equity holdings are relatively few. He further states that he looks into:
Favourable long-term economic characteristics,
Competent and honest management,
Purchase price attractive when measured against the yardstick of value to a private owner,
An industry with which we are familiar and whose long-term business characteristics he feels competent to judge.
It is difficult to find investments meeting such a test and that is one reason for our concentration of holdings. We simply can’t find 100 different securities that conform to our investment requirements. However, we feel quite comfortable concentrating our holdings in the much smaller number that we do identify as attractive.
When such an opportunity arises, he pounces:
“Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble.”
On the other end of the spectrum, some investors excessively diversify their portfolios out of fear and/or ignorance. Owning 100 stocks makes it virtually impossible for an investor to keep tabs on the current events impacting their companies. Excessive diversification also means that a portfolio is likely invested in a number of mediocre businesses, diluting the impact from its high-quality holdings.
“Diversification is a protection against ignorance. It makes very little sense for those who know what they’re doing.”
5. Most news is noise, not news
There is no shortage of financial news hitting your inbox each day. Most of the news headlines and conversations on the television are there to generate buzz and trigger our emotions to do something – anything!
“Owners of stocks, however, too often let the capricious and often irrational behaviour of their fellow owners cause them to behave irrationally as well. Because there is so much chatter about markets, the economy, interest rates, price behaviour of stocks, etc., some investors believe it is important to listen to pundits – and, worse yet, important to consider acting upon their comments.”
The companies I focus on investing in have thus far withstood the test of time. Many have been in business for more than 100 years and faced virtually every unexpected challenge imaginable. Imagine how many pieces of gloom-and-doom ‘news’ originated over their corporate lives. However, they are still standing.
As investors, we need to ask ourselves if a news item truly impacts our company’s long-term earnings power. If the answer is no, we should probably do the opposite of whatever the market is doing. The stock market is an unpredictable, dynamic force. We need to be very selective with the news we choose to listen to, much less act on. In my opinion, this is one of the most important pieces of investment advice.
6. Investing isn’t rocket science but there is no “Easy Button”
Perhaps one of the greatest misconceptions about investing is that only sophisticated people can successfully pick stocks. However, raw intelligence is arguably one of the least predictive factors of investment success.
“You don’t need to be a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ.”
It doesn’t take a genius to follow after Buffett’s investment philosophy but it is remarkably difficult for anyone to consistently beat the market and sidestep behavioural mistakes. Equally important, investors must remain aware that there is no such thing as a magical set of rules, a formula or an “Easy Button” that can generate market-beating results. It doesn’t exist and never will.
“Investors should be sceptical of history-based models. Constructed by a nerdy-sounding priesthood…these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the models. Beware of geeks bearing formulas.”
Anyone proclaiming to possess such a system for the sake of drumming up business is either naive or no better than a snake oil salesman in my book. Beware of self-proclaimed ‘gurus’ selling you a hands-off, rules-based system to investing. If such a system actually existed, the owner certainly wouldn’t have a need to sell books or subscriptions.
Adhering to an overarching set of investment principles is fine but investing is still a difficult art that requires thinking and shouldn’t feel easy.
We often make investing harder than it needs to be. Buffett follows a simple approach rooted in common sense. I can certainly relate to his investing tips from my experience working as an equity research analyst but that doesn’t mean they are always easy to follow!
By embracing some of Buffett’s investment advice – focusing on the longer term, sticking to blue-chip dividend stocks, remaining within our circle of competence – we can better manage our portfolios to reduce the number of costly errors we make and continuously move closer to achieving our goals.