Saturday, 18 April 2015

Investing Lessons of Warren Buffett

Warren Buffett is arguably the greatest investor of all time. But more importantly, he’s also one of the best teachers of investing. In his annual reports and countless interviews, he freely offers priceless wisdom that helped him become a billionaire, and that you can use to invest better and reach your financial goals sooner. Here are some of the lessons I’ve learned from him that have helped me achieve more success in investing, business, and life.

1   Stockpicking isn’t a hobby.
Everyone should be an investor. But not everyone should choose their own investments. To be a successful investor requires thousands of hours of deliberate effortful study to master the necessary skills, and then thousands more (or in Buffett’s case, tens of thousands) to use those skills to find worthwhile investments. Buffett read every investing book in his local library, many of them multiple times… by the time he was eleven years old. If you aren’t willing to put in the time and effort that stockpicking requires, the person on the other side of your trades is likely to know more than you, which is a recipe for underperformance. In that case, you’re better off simply buying a low-fee index fund which passively tracks the market, like VFINX, which tries to match the S&P 500. All of the lessons below are relevant for active investing, but many of them also apply to passive investing, so I encourage you to read on regardless of whether you decide to pick stocks yourself or just buy the entire market.

[Extra for experts: market-weighted index mutual funds like VFINX hold more in stocks that have already risen and less in stocks that have already fallen, which reduces returns because stocks that are up tend to slightly underperform those that are down. As an alternative, consider RSP, the equal-weight S&P ETF from Rydex, which has historically outperformed market-weighted S&P index funds by 1-2% per year.]

2  Invest unemotionally.
It’s human nature to be emotional, and life is richer for it. But it reduces investment returns. Many people make systematic errors in their investment thinking, due to their emotions, egos and innate cognitive biases. They suffer from confirmation bias, tending to seek out and find evidence to support their position rather than evidence that might refute it. They think about risk more when things are already going badly and less when prices are already up. They resist admitting mistakes and hold their losers too long. They think about how they’ll spend the money they’re expecting to make from investing, and this can cloud their judgment and encourage excessive risk-taking. They’re overly optimistic and overly confident about their investment abilities, which is dangerous. By contrast, Buffett is a paragon of rationality. His investment decisions are insulated from such emotionality. He has said he’d never give up a good night’s sleep for a chance at a slightly better return. He thinks long term and so he doesn’t panic when the market falls; instead, he sees drops as buying opportunities. To invest better, become a student of human psychology. Learn how emotions lead to cognitive errors, so that you can avoid those errors and benefit when others make them.

3  Ignore modern financial theory.
Buffett says modern financial theory is fundamentally flawed. His consistent long term success is evidence that the efficient market hypothesis is wrong. He says beta is a silly way to measure risk. He thinks diversification is counterproductive for anyone skilled at investment selection. He says financial models oversimplify things, underestimating the frequency of black swans and assuming that what hasn’t happen can’t happen. Markets are more dependent on behavioral science than physical science, but the models don’t adequately factor in human behavior. Investing is part art and part science, and the models don’t capture the artistic side of the process. Buffett says you’re better off ignoring most of modern financial theory.

4  Invest in what you understand.
Buffett stresses the importance of having a circle of competence, a clearly defined industry, business model, asset class, investment style, or other area that you are an expert at, and investing only within that circle. You should continue to learn and thereby expand your circle of competence, but until you do, you shouldn’t invest where you aren’t yet skilled. Buffett has said that an investor needs to do very few things right as long as he or she avoids big mistakes, and staying within your circle of competence is one of them. This is closely related to Buffett’s suggestion of investing only in what you understand. He has three mailboxes on his desk, labelled “In”, “Out”, and “Too Hard”. Every business has factors which are knowable, unknowable, important, and unimportant; he recommends investing in businesses for which the important factors are knowable. He wants understandable businesses because he intends to hold long-term and wants to be able to predict roughly what the business will look like in five or ten years. He puts most technology companies in the too-hard pile. Tech changes so fast that there are only a handful of people in the world with the expertise to tell which will be spectacular successes and which will be spectacular failures. If you aren’t in that elite group, it’s best to look elsewhere. Buffett has said that investing isn’t like Olympic diving, where you get more points for a difficult dive than a simple one. Or to use another sports analogy, he doesn’t try to jump over seven-foot bars, he looks around for one-foot bars he can step over.

5   Stock ownership is business ownership.
When you buy a stock, don’t think of it as a line on a chart that you hope will move up. Think of it as partial ownership in the underlying business. Unlike collectibles or precious metals, stocks have intrinsic value because your ownership gives you a proportional claim on the company’s future earnings, in the form of dividends. If a business does well over time, the stock price eventually follows. Buffett sees himself not as a market analyst, or a macroeconomic analyst, or even a security analyst, but as a business analyst. He likes managers who think like owners, and especially ones who actually are owners. He has said that he’s a better businessman because he’s an investor, and a better investor because he’s a businessman. This leads directly into the next point…

6   Know what a good company looks like.
The list of essential characteristics Buffett looks for in an investment is surprisingly short. He wants a business that’s easy to understand, with a consistent operating history; good long term prospects, possibly due to some durable competitive advantages, or “moats”; a trustworthy, high-quality management team; and solid financials: high margins, high return on equity, and high free cash flow. He does like growth, but less so than investors who are focused on the short term, since it’s the nature of capitalism for growth not to last more than a few years as outsize profits attract fierce competition. When asked what metrics he uses in his investment decisions, his response is that if a computer could do valuation then everyone could do it, and if everyone could do it then the market would be efficient and there would be no bargains. Number geeks want math to provide easy answers, but it doesn’t. Buffett’s style of investing is at least as much art as science.

[Extra for experts: To be precise, rather than free cash flow, Buffett uses what he calls “owner earnings”. This is defined as net income from operations, plus depreciation, depletion, and amortization, minus your best estimate of the average annual capitalized expenditures that the business requires to fully maintain its long-term competitive position and its unit volume. In other words, money the business is generating that doesn’t need to be spent just to avoid falling behind.]

7   Be cheap.
OK, now you know what a good company looks like. But you shouldn’t simply buy every good company you find, because good companies tend to be more expensive. The key to Buffett’s strategy is to find good companies at good prices. Price is what you pay; value is what you get. When value exceeds price, the difference is what Buffett’s mentor Ben Graham called a margin of safety. A large margin of safety enables you to be successful even if your valuation is slightly off or if things play out slightly differently than expected. Early in his career, Buffett preferred good companies at great prices. Later, perhaps because he had too much capital to deploy every year on finding new bargains and he began holding investments much longer, he shifted to preferring great companies at good prices. Both approaches are valid.

8   Be patient.
Above I mentioned the importance of not letting emotions impact your investment decisions. A closely related point is the value of patience. Buffett has said that investing differs from baseball in that there are no called strikes. You can stand at the plate all day and not swing if you don’t see any pitches you like. This can be difficult because the financial system encourages frequent trading, since its revenues grow as transaction volume grows. But great investment opportunities are rare; at most times and for most stocks, the market is pretty good at keeping price roughly in line with value. To resist the temptation to trade in and out of positions, Buffett suggests pretending you can only make twenty trades your whole life. Under this restriction, you’d be much more likely to do detailed research, and only move forward on a trade if you were very confident in it. This would force you to be patient both when buying and while holding. Another dimension of patience relates to time horizon. The right mentality is get rich slow, not get rich fast. Too many investors can’t wait to reach their financial goals, and focus on quarterly performance and keeping up with benchmarks. This encourages them to sell whatever has recently underperformed (at a loss) and buy more of whatever has recently outperformed (after it’s already risen), which usually doesn’t work. Even investment professionals feel short-term pressure, justifiably fearing that one bad quarter or year could cause their clients to pull their assets. It’s dangerous to try to outperform the market in the short term. You don’t need to, and you’re better off not trying. Others feel the need to, and you can use this to your advantage as well.

9   Be loss-averse.
Too many on Wall Street measure performance based solely on return. A better measure is risk-adjusted return. Don’t strive to make every last dollar of potential profit; doing so exposes you to too much risk. Instead, make preservation of capital your top goal. By staying focused on loss avoidance, you’ll naturally gravitate toward investments with more upside potential than downside potential, which will help your returns. And by always looking for a margin of safety, your returns will still be adequate even if events don’t play out quite as expected. It’s not necessary to do extraordinary things to get extraordinary results, it just requires avoiding big mistakes, and letting compounding work its magic over long periods of time. Buffett says it like this: Rule One, do not lose money. Rule Two, see Rule One.

10   Volatility is your friend.
Many investors think volatility is the same thing as risk, but it’s not. Being risk-averse doesn’t mean avoiding volatility. Berkshire Hathaway stock has suffered a quotational loss of 50% or more three times in its history. But remarkably, Buffett has never lost more than 2% of his personal worth on any single position. He achieved this not by diversifying; indeed, he tends to be heavily concentrated, and at one point early in his career, he had 75% of his net worth in Geico. (Kids, don’t try this at home!) He achieved it by buying good companies at good prices, and then buying more shares if prices fell. Don’t fear the market’s gyrations. Volatility is the best friend of the unemotional, patient, debt-free investor. A wildly fluctuating market means that solid businesses will occasionally be available for you to buy at irrationally low prices. Ben Graham said that the market is a voting machine in the short run and a weighing machine in the long run. If you buy good companies at good prices and the prices fall, you can be confident that eventually the market will realize the companies deserve to be priced higher, and in the unlikely event that they don’t, you can wait and collect an ever-growing stream of dividends.

[Extra for experts: To further clarify the difference between risk and volatility… You can have risk without volatility: for example, selling far out of the money options, you’ll have very nice returns until the tail event occurs, and then you’ll get crushed. And you can have volatility without risk: for example, when Kyle Bass bought twenty million nickels, which had a metal value of seven cents each and a floor of (obviously) five cents.]

11   The market is there to serve you, not to inform you.
Ben Graham had a thought experiment that Buffett frequently used. Imagine the stock market as a single person, Mr. Market, who’s willing and able to buy any stock from you or sell any stock to you. Mr. Market is often rational and the prices he sets are often reasonable, but occasionally he gets emotional or irrational and the prices swing wildly in one direction or the other. When he’s rational and offers no great deals, you are free to ignore him. (Hence the importance of patience.) When he’s greedy, you can sell to him at a premium. When he’s fearful, you can buy from him at a discount. Don’t underestimate his intelligence, because he’s usually approximately right, which is why deep research and a solid investment framework are essential. But don’t look to him for guidance about the actual value of things; instead, look to him for opportunities when his prices diverge from underlying value.

12   Think for yourself.
Investment noise is everywhere. Financial news programs are more about speculation than investing, their pundits always ready with a superficial one-minute analysis of whatever stock is in the news that day. Brokerage reports are more about promotion than investing; buy recommendations greatly exceed sell recommendations because buy recommendations generate underwriting business for the brokerages and sell recommendations get them cut out of earnings calls. Wall Street is remarkably innovative. But financial innovation is more about selling than about value creation. If someone is actively trying to sell something to you, you probably shouldn’t buy it. Berkshire Hathaway has not bought an IPO in thirty years; Buffett says it’s exceedingly unlikely that out of all the thousands of stocks on the market, the most attractively priced one will be one being sold by highly knowledgeable insiders who control the timing and price of the sale. Living in Omaha has made it easier for Buffett to ignore the noise; he says that when he lived in New York City he had fifty people whispering in his ear before noon. There are great investment opportunities, but they won’t be featured on CNBC, they won’t be in brokerage reports, and your friend won’t know about them. You’ll need to do your own digging. Optimism and pessimism are both contagious, as are greed and fear, so if you don’t tune out the noise, you’re likely to get swept up in it. In a market bubble, skeptics look like idiots and lemmings look like geniuses, until the bubble bursts. Don’t care if you look like an idiot. Ignore the crowd.

13   Be selectively contrarian.
This is closely related to the prior point. Sometimes it’s best not to merely ignore the crowd, but to see which way they’re going and explore whether it’s worth going the other way. Buffett often buys when the lemmings are selling, and vice versa. It’s hard to buy what’s popular and do well; speculation is most dangerous when it looks easiest, and as Buffett says, the market pays a high price for a cheery consensus. He recommends being fearful when others are greedy, and greedy when others are fearful. The single best-performing mutual fund for the decade of the 2000s was up an average of 18% a year, but the average investor in the fund lost 11%. Incredible, but true. How is this possible? The fund did well, and investors piled in (after it was already up). Then the fund did poorly, and investors stampeded for the exits (after it was already down). So on the balance it’s beneficial to have a contrarian mindset, to buy when others are selling and sell when they’re buying. But don’t be contrarian just to be contrarian. Sometimes the market is right, which is why you need to do your homework. The key is to be both contrarian and correct.

[Extra for experts: A secondary reason for this fund’s underperformance when AUM was high and outperformance when AUM was low is that as with any large fund, when assets balloon, it tends to hurt performance for a variety of reasons: excess cash; style creep; forced diversification; etc. By the way, in case you’re curious, the fund in question is CGM Focus.]

14   Learn from the masters.
Above I suggested tuning out the noise. But if you tune out everything, it will be hard to keep learning, and continued learning is essential to investment success. So find some experts who have a proven record of outstanding risk-adjusted performance in good times and bad, and who openly and honestly share their lessons, and then listen only to them. Buffett is a good place to start, but there are many others. Buffett himself saw the wisdom of this strategy at an early age, and straight out of school he specifically wanted to work for Ben Graham, the one person in the world he thought he could learn the most from. You probably can’t work directly for Buffett, even if you offer to do it for free, as Buffett did to Graham: Berkshire Hathaway is so efficient that although its companies employ over a quarter of a million people, only about two dozen people work in Berkshire headquarters. And you probably can’t get 1-on-1 time with Buffett either; when he auctions off charity lunches they generally cost a couple million dollars. But you can still learn a lot from him, indirectly. This article is just a small fraction of what he has to teach. I recommend starting with his annual reports, which are not just informative, but entertaining as well. And you can learn directly from other great investors. Try to find the next Buffett, and see if he or she is willing to mentor you. This applies not just to investing, but to whatever your career might be. Identify the experts in the field, the ones with the most to teach, the ones you admire most, and start building relationships with them.

15   Avoid taxes.
Like all billionaires, Buffett has always been obsessed with tax efficiency. When he was thirteen he filed his first tax return, claiming a $35 deduction for the bike he used to deliver newspapers. Over the years his assets grew, and the size of potential tax benefits grew, so he became increasingly tax savvy. Know the tax laws and use them to your advantage. Know how an investment will be taxed before you buy it. Avoid highly taxed short-term capital gains, or use short-term losses tactically to offset them. If possible, structure your assets or your business or your career to emphasize capital gains rather than income, which generally has higher tax rates. If you have enough money for it to be worthwhile, get professional tax assistance, because some easily avoidable mistakes are very expensive. Note that I said avoid, not evade. Pay all the taxes you are legally required to, but no more than that.

16   Invest in yourself.
Buffett often speaks to business school students, and when he does he sometimes gives them the following thought experiment. Imagine that you can invest in one of your classmates, and be entitled to 10% of their future earnings. Who would you choose? What are the characteristics that person would possess? He says that most people wouldn’t simply choose the student with the highest IQ. There’s often a big difference between potential and actual. They’d be more likely to choose someone not satisfied with mediocrity, someone who is driven to excel. They would probably also have a lot of other positive characteristics, like generosity, integrity, and sociability. The point of the exercise is to show the students that the skills they’d be looking for aren’t innate for some people and not others, but are skills that anyone cultivate. Everyone has the potential to be the person worth investing in. So consciously choose to develop those positive traits, to realize your full potential, to become the kind of person others would want to invest in. Best of all, when you invest in yourself, you won’t just get 10% of the benefit, you’ll get the full 100%.

17   Do what makes you happy.
Buffett’s lessons extend beyond investing and business. One of his best suggestions is to do what you love. He’s certainly not the first to give this advice, but he definitely practices what he preaches. One of Buffett’s biographies is entitled “Tap Dancing to Work.” Buffett would rather read quarterly earnings reports than chill on the beach or hang out with celebrities. And this is why he’s such a good investor. To invest well requires mastery; to achieve mastery requires tremendous effort; and to be willing to put in the effort requires lifelong passion. He’s living exactly the life he wants to, because investing is his calling. If you don’t love investing, then just dollar cost average into a low-cost index fund and spend as much time as possible on the things in life that you love.

by Thomas Murcko, CEO of

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