Warren Buffett's Approach to Investing
By Dale Gillham | Last Updated 21 June 2019
Warren Buffett, also known as the Oracle from Omaha, is arguably the greatest investor of all time. Buffett is the CEO and largest shareholder of Berkshire Hathaway, who has amassed an astonishing US$482.9 billion in personal wealth making him the third wealthiest person in the world. Therefore, it comes as no surprise why his philosophy to investing is so popular.
So how does Warren Buffet invest and why is he so successful? What follows are 8 principles that Buffett implements in his approach to investing. In discussing these principles, I will also provide my perspective on why I believe some of these may not be relevant in today's environment.
1. Long term value investing
Warren Buffett's strategy is based on long term value investing passed down from his mentor Benjamin Graham. According to Benjamin Graham, long term value investing involves purchasing stocks at prices below their intrinsic value and then holding them until their price reflects the real value of a company.
According to Buffett, the secret to getting a better return on your investments is to buy a stock and forget about it. He believes in the buy and hold mentality, and insists on holding stocks for decades. Buffett has even been quoted as saying: "if you're not willing to own a stock for 10 years, don't even think about owning it for ten minutes."
Further, he states that if you constantly buy and sell stocks, it will take away a significant percentage of your returns in the form of trading commissions and taxes. So, it is better to buy great stocks and hold them for the long term.
While I agree with Buffett on most things, as a trader I have some a different perspective in regards to the long term buy and hold mentality, as modern day technology has made brokerage very cheap and pretty much insignificant in the big scheme of things.
Further, the ease and speed with which transactions can be achieved in today’s market means that holding stocks over the long term does not allow you to compound your returns by buying low and selling high. Even after factoring in capital gains tax, I have found that you will gain far better value by actively managing your portfolio rather than applying a passive buy and hold approach.
In fact, from experience I can say that you will achieve far better returns by timing the market than you will spending time in the market. Therefore, while I agree that you should stick to investing in good quality stocks, it is important that you learn to manage the investment risk of holding stocks over the long term.
2. Diversification is not always a good idea
Many knowledgeable investors understand the importance of diversification; in fact, it is an industry mantra. But Warren Buffett tends to disagree with this idea and so do I, particularly when it comes to over-diversification.
Buffett has stated that diversification is for people who do not know much about investing. In fact, investors over-diversify their portfolio because they are afraid that any one stock might sink their entire portfolio.
An experienced investor, on the other hand, should choose stocks on a long term basis and have faith in their investments.
While the concept of diversification was designed to reduce volatility within a portfolio, what I have discovered is that over-diversification, which is what the financial services industry advocates, has the effect of reducing portfolio returns. Based on research and my experience of investing over the past 20 years, a well-diversified portfolio should only hold between 5 and 12 stocks, as this will allow you to maximize your returns while minimizing your risk.
So while Buffett states that it's better to wait for opportunities to buy good stocks to take advantage of the upside, I don't support holding stocks on a long term basis. That's because when a stock turns, it can fall anywhere from 9 months to three years into a long term low, which means you have lost the opportunity of investing in another stock that is rising in value.
3. Invest in yourself first
"The best investment you can make is in your own abilities. Anything you can do to develop your own abilities or business is likely to be more productive," and I totally agree with Buffett on this point.
Buffett also says that the hardest thing to do when investing in the stock market is to trust your investment decisions, which often stems from not having the knowledge or expertise to understand the risks you are taking.
Given this, doesn't it make sense to invest in yourself first by gaining a proper trading education that will ensure you are successful over the long term? Why waste valuable time hoping to win, when you can invest with knowledge knowing you are going to win more times than you lose.
Unfortunately, too many do the opposite of what Buffett advocates by making themselves dependent on others, such as brokers, stock reports and tips from friends and family, to name a few.
But knowledge overcomes fear. Indeed, the fear of failure or the fear of being wrong is easily overcome by acquiring the correct knowledge.
Unfortunately, if you continue to rely on others to tell you what to invest in, you will continue to subject yourself to emotional decision making, which is not the most effective way to succeed in the stock market.
4. Buy quality companies
Buffet believes in investing in quality companies and who would argue with that. He would rather pay a fair price for a great company than a low price for a mediocre company.
In my latest award winning book, Accelerate Your Wealth - It's Your Money, Your Choice, I share how all too often people buy stocks that they perceive to be cheap with the intent of getting a bargain. But this belief not only costs you money, it usually hinders your ability to generate profits because you are investing your faith in speculative stocks. In other words, you are speculating that a cheap stock will perform better than a solid blue chip stock.
In my experience, however, when investors buy cheap stocks trying to get a "good buy", they usually end up saying goodbye to their money, which explains why so many traders fail when trading the stock market. Therefore, I totally agree with Buffett, as your aim should always be to buy quality stocks, not quantity, because this is where you will get the greatest gains.
5. Invest in companies and industries that you understand
While most people will agree that it makes sense to only invest in companies and industries that you understand, unfortunately too many also get caught up in the hype and speculation of certain investments, such as cryptocurrencies. But Buffett cautions that you should never invest in assets that you do not fully understand.
Before Buffett invests, he has to understand how the company (or investment) works to make money, and the main drivers that impact its industry. If he's not able to understand this in 10 minutes, he moves on to evaluate another investment on this basis, which makes sense.
When teaching traders, one of my mantras is to keep things simple and I believe this is what Buffet is saying. All too often, individuals invest in markets or companies they do not understand, which causes emotional decision making and poor returns.
If you don't possess the knowledge to understand how the market works or the risks of investing, you are better off sticking to the top 20 stocks in the market, as these represent the least amount of risk.
6. Buying shares is buying a part of a business
Imagine you are buying an ownership stake in the convenience store around the corner from your house. You would automatically think about the competition, suppliers, prices, etc. You would also consider both the specific location of the store, as well as its competitive position in the market.
Similarly, when buying shares on the stock market, you need to be able to analyze this information using both technical and fundamental analysis to ensure you are investing in a quality company that will rise over the medium to long term.
Unfortunately, too many people treat the stock market and the buying and selling of shares like a place to gamble, which occurred during the tech wreck and other market booms and busts, where the masses invested in assets that had little or no intrinsic value or profits. With the right knowledge, however, you can avoid these costly mistakes, so that you protect your downside.
7. Manage your risk
This is one of my favourite topics because I find that while the majority understand how to manage risk on an intellectual level, very few are able to do it well.
According to Buffett, his number one rule is to never lose money. His second rule is to never forget rule number one. His other famous quote is to understand that risk comes from not knowing what you're doing.
From experience I can honestly say that 90 per cent of traders and investors do not understand how to manage their risk so that they minimize their losses. While many will state they have rules to exit their losing trades, unfortunately many fail to follow through and consequently end up losing their capital.
But as Buffett states, when a company no longer fits his criteria, he sells. Therefore, I encourage you to resist the urge to make excuses to stay in an investment, when the risk of holding it becomes too high. In fact, knowing when to sell your shares is critical to your longevity in the stock market.
8. Learn from your mistakes and move on
You might be surprised to learn that even Warren Buffett makes mistakes, he makes sure that he learns from his mistakes.
Buffett advises keeping a record of the mistakes you have made so you know what went wrong and to ensure you don't repeat the mistake again.
Documenting your mistakes is a way of taking responsibility for them because all too often we sweep these under the carpet, as if they never occurred. But being disciplined and accountable are both great traits of excellent traders.
Buffett further states that you should share these lessons with your children and grandchildren, so they have the opportunity not to commit the same mistakes. I really appreciate Buffett for not only sharing his lessons with his family but also with the world.
Unfortunately, while his words of wisdom are very valuable, the majority either do not listen or do the opposite, although for your sake I hope you are one of those who does listen.
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