Value investing practice grows by learning from investors who have come before us and found success. Although I no longer put Warren Buffett in the category of classic value investors in Ben Graham‘s mould, he does espouse some of the key philosophies that we all can learn from.
I recently took him to task by rebutting his contention that book value is no longer relevant. This was not to portray any lack of respect on my part – au contrary, Buffett will be the first to tell you to learn from others but keep your own counsel.
This article lays out the top 9 investment advice that Buffett has imparted over his considerable career, and I along with countless other value investors have learned from. I am sure you will find considerable value in this list of key value investing principles.
The Top 9 Pieces of Investment Advice from Warren Buffett
1. Investing is a long game
Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.
How long are you willing to stay with an investment, if it does not perform the way you expect?
These are hard questions and they go deep into your suitability as an investor. Not everyone is well disposed to be an investor, and not everyone should invest on their own. Most people are looking for validation – they need a sign quickly that their investments are good. The only way to play the long game is to be utterly confident in yourself as an investor.
How can you be so completely confident that a market disruption does not shake you off your investments?
By knowing your investments well.
2. Know your investments well
What an investor needs is the ability to correctly evaluate selected businesses.
You need to remove all the risk in your mind before you invest in any stock. There are 2 ways you can go about doing this
- Use external tools to “remove risk”, without spending time to understand what the risks are. For example, you can blindly diversify your portfolio to hedge against the “risks” you don’t even know exist. The downside of this is that you also “hedge away” your returns.
- Know everything there is to know about the business so you completely understand the fundamentals and the business specific risks. If you know what makes the business tick, what drives the industry, where are the strengths, what is the management strategy, etc., you can indeed not worry about your investment if the market shuts down for 10 years. Why? Because now you are thinking more like a business owner, and less like a speculator or a passive indexer.
Also please note the use of the phrase “selected businesses”. You do not have time or skills to understand every business or industry or company that exists. You have to figure out and become an expert in selected businesses. You need to operate in your ‘circle of competence’.
This is the only way.
3. Diversification is not always a good idea
Diversification is protection against ignorance. It makes little sense if you know what you are doing.
Risk comes from not knowing what you are doing.
We have written quite a bit about why kind of diversification the you do, if you are like most investors, is unnecessary and destructive. Here we write about why too much diversification will bring mediocrity to your investments. In this article we talk about dangers of diversification and how many stocks are enough.
However, I do want to reiterate this.
You want to diversify because you want to cut down on the “risk”. You have “risk” because either you don’t understand the investment or business, or you do not have the appropriate long term orientation. You diversify by buying more stocks, that you understand even less. Sure, you will eliminate some risk by the random chance of something cancelling out something else. But you are also increasing your correlation to the market and at the same time reducing your potential returns.
All because you do not wish to spend time learning about the business you are investing in (or finding someone who does).
Yes, you should own multiple stocks. Each stock should have its own thesis. But if you have only 1 idea, does this make your portfolio very risky because it is not diversified)?
I don’t think so, unless you decide to put 100% of your capital in this one stock that you know not much about. Nothing compels you to do this.
You do have a choice to invest according to your convictions.
4. Be patient
Stock market is designed to transfer money from the active to the patient
What do you get when you cross conviction with long term orientation?
You get patience. And patience is the absolute requirement to succeed in your investment career.
This also means that day trading or frequent transactions are not advised. Transaction costs, of course are a big factor, but also worth noting is that when you do this, by necessity you are putting less trust in the business you are investing in (you are only in there for a quick profit), and you are putting more trust in other investors to be greater fools than you (they will create opportunities for you to make quick profit).
When you invest with patience, you trust the business to create value over time, and you trust that the value of the stock will reflect the improving business value. You are trusting the economic system to continue working the way it has since man started trading berries for tools.
Unfortunately, patience is in short supply.
The research firm DALBAR finds that an average investor underperforms the funds they have invested in by over 4% annually, by constantly getting in and out at the wrong times (for example, buying when things are looking great, and selling when the mood is sour, the exact opposite of buy low and sell high).
5. Never lose money
Rule No. 1: Never lose money. Rule No. 2: Never forget Rule No. 1
Great investments compound your portfolio. You do not wish to reverse the compounding effect. It is easier to not invest in ideas you do not feel confident about, then to invest and lose money and set your portfolio back a few years.
Or put it in more tangible terms, it takes 20% to grow from $100 to $120. However, if you lose 20% of your $100 capital in one year, you will need another 3 years of 20% annual growth to grow past $120. That is setting you back 3 years. You can choose to not invest in a shaky idea and look for another that you feel more confident about.
This is the mathematical reason anyway.
Psychologically, if you follow this rule, you will be more diligent in finding investments that will be profitable. You will be more diligent in considering all sorts of risks before you make an investment. You will be more diligent in insisting a margin of safety to cushion you in case somethings don’t turn out the way you expect, as things inevitably will.
6. Price does not equal value
Price is what you pay. Value is what you get.
This is the core tenet of value investing. This is also a repudiation of the Efficient Market Hypothesis.
It is possible to buy a dollar with 50 cents.
But it takes time and effort and skill to peg a value of a dollar to an investment that is selling for 50 cents. Most investors are not able to do this, so they don’t. They look for stocks that sell for a dollar today and are likely to be worth $2 tomorrow based on some complex projections and analyst sound bites.
Speaking of sound bites, we are all taught as a kid “A bird in hand is worth more than two in a bush”.
An undervalued stock is a bird in hand. But still, investors would rather chase the two in the bush.
7. Investing is simple, but not easy
The business schools reward difficult complex behavior more than simple behavior, but simple behavior is more effective.
The way I judge my investment theses is how simply can I explain it to a 5 year old. If I can’t do it well, than maybe I do not understand the business well. Or the business is just too complex.
If I have to build an excel model to forecast 10 years of earnings at a certain growth rate and a terminal value and figure out the value of the cash flow, all well grounded in theory by the way, it just means that I do not understand the business enough to invest in it.
This is also the reason why I gravitate towards smaller company stocks. A company with 1 or 2 products or services is much easier to understand and profit from.
The simplicity requirement pervades all aspect of investing.
For example, my businesses do not need to have a strategy for everything. They just need to do what they do well, and if they can’t, return the money to the shareholders.
The Occam’s Razor comes into play as well. You can question yourself a thousand ways. For example, I get asked this question frequently: “if the stock has such and such value, why is it selling for less?”. The simplest answer is, most investors do not know of the value. This answer is most likely to be true, but yes, people have many complex hypothesis and eventually they talk themselves out of a lucrative investment.
8. Load up the truck when you find a great opportunity
Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble.
What does “load up the truck” mean?
it is not a call for you to be indiscreet. It just means invest according to your convictions. You buy more of the stock that you feel a greater conviction for. You buy less or none of the stock that you do not have enough conviction for. I cannot give you a formula for this, although there is a mathematical formula to maximize your wealth. I will just say that you will figure this out with experience.
9. Doing nothing is often wise
You do things when the opportunities come along. I’ve had periods in my life when I’ve had a bundle of ideas come along, and I’ve had long dry spells. If I get an idea next week, I’ll do something. If not, I won’t do a damn thing.
A simple idea but so hard to execute.
Some people believe that there is always something there that you can invest in. Sometimes there is not, unless you violate other tenets of good investing such as staying within your circle of competence, or being patient, or need to understand the business well, etc. Some investors are compelled to buy something, anything, because they do not have the long term orientation. They need to see the profits NOW. And if it doesn’t work out, there was something wrong with the stock.
Doing nothing when it is the wisest thing to do is you taking responsibility for your investments.
Doing something in haste because you just have to get into something, is being irresponsible.
Take Buffett’s Advice. These Investing Principles will Help You Create Your Own Investment Approach
These are the 9 nuggets of Warren Buffett’s investing principles that I find incredibly important to learn and live for me as a value investor. None of these go into the actual mechanics of finding undervalued stocks. These advice do not talk about any investment strategies. They do something more important. They teach you the right investment mindset. Tools and strategies do not work if you do not know how and when to use them.
Let these make up your investing operating system.