The Trouble With Buffett
Warren Buffett is the world's most successful investor. His investment strategy works marvelously well - for Warren Buffett.
In our experience many small investors have lost money trying to follow in Buffett's footsteps. Not that there is anything wrong with Buffett's methodology per se - his awe-inspiring record of success speaks for itself. The problem is that the small, beginning investors who find his folksy investment-talk most appealing often find it very difficult to replicate his techniques successfully.
For a good number of years now, Buffett's preference has been to buy companies outright. In this article, however, we shall concentrate on Buffett's stock investing methods, because it is these methods that small investors want to mimic.
How Does Warren Buffett
Identify The Stocks He Would Like To Own?
Warren Buffett works with a list of companies whose stock he would like to own.
He compiles his list by studying companies and their management teams in considerable detail.
His favorite type of stock is of a company with a uniquely competitive market position.
Often the competitiveness arises from the strength of a brand name, such as Coca-Cola or Gillette.
He buys a stock if and only if its share price drops below its long-term value (intrinsic value).
He is prepared to wait years for an opportunity to buy stocks at the right price.
Buffett calculates the price he is willing to pay for a stock by estimating its future earnings. He then uses this estimate to predict what the stock will be worth in the future. In order to accomplish this with reasonable accuracy, he demands the company can demonstrate more-or-less consistent earnings growth for at least five years - preferably longer. Buffett buys stocks when their prices are at low enough levels to offer him a high probability of significantly outperforming returns offered by government bonds.
If stocks he likes don't reach his target price, Warren does not buy - no matter how much he may like the look of them. He says that paying too much for a stock is a good way to guarantee a poor return.
If stocks he likes become available at or below his target price, he buys big. Then he waits. This is the "classic" and best-known Buffett investment method. (He has several.)
After he has bought a stock, his preferred holding time is "forever," although he concedes that it is sensible to sell a stock if it becomes grossly overvalued.
Over time, his stock buying decisions have been amply rewarded.
Patience And The Concentrated Stock Portfolio
Buffett advocates that investors hold a "concentrated stock portfolio".
At any time you should own a very small number of stocks, say six at most, and you should know everything there is to know about these stocks.
In total, in a lifetime of investing, you should buy and sell no more than twenty times.
Buffett says: "An investor should act as though he had a lifetime decision card with just twenty punches on it. With every investment decision his card is punched, and he has one fewer available for the rest of his life." In a lifetime of investing this might result in, for example:
- twenty stock purchases and no sales
or
- ten stock purchases and ten sales.
The Trouble With Warren Buffett's Methods
Unfortunately, small investors often fail to implement Buffett's strategy successfully.
For one thing, many of us - Buffett included - learn investing through trial and error.
Sure, we read as much as we can before we begin, but reading isn't enough.
It's only when you've put your own savings on the line and lost money that you really learn.
Making mistakes is how the majority of us learn our most important lessons.
But if you've got to wait five years before a stock you'd like to own becomes available at the right price, then you're going to miss out on a lot of market experience. And what if it turns out you waited five years to make your first mistake? The next five years will give you a lot of time to reflect on that. You'll just have to hope that you will learn enough from your first mistake not to make a second. So, we would reiterate - it takes a lot of practice before a baseball player consistently hits home runs from perfect pitches.
Small investors who want to invest like Warren Buffett fail because they do not have access to the quality of information Buffett has. Compared with most of us, Warren Buffett has enjoyed a privileged position from the very beginnings of his career. He is the son of a United States Congressman - a Congressman who was also a stockbroker.
For most of his life, Warren Buffett has been able to chat with and gather information and advice from CEO's and other big movers that small investors have no access to. Warren began trading in stocks at the tender age of 11 years.
Beginning investors fail because they learn in "How to be a New Warren Buffett" books that they must invest with a ten-year perspective or longer. When their stocks go up, they're happy. When their stocks do down, they're less happy but they tell themselves "I'm a long term investor". When their stocks continue to go down, they get worried. When their stocks go down even further, they eventually give in and sell - at a big loss. They do not have the long-term confidence in their stocks that Buffett - through superior information sources and superior market experience - has in his. Those investors who do have confidence in their stock picks often find their confidence is misplaced. They doggedly hold on to inferior stocks, believing they are following the Buffett way. In reality they aren't and they will not be rewarded because they paid too much in the first place for inferior stocks. Buffett buys his stocks with a skill few of us can match.
Far from trying to exercise patience, some small investors, filled with sheer enthusiasm (and a hint of greed) from reading "How to Become A Millionaire Like Warren Buffett" rush out and buy stocks. Unfortunately, most of them pay too much for their stocks or the stocks don't have as good long-term prospects as Warren's own picks.
Beginning investors fail because, in addition to lacking Buffett's superior access to information, they lack his temperament. Buffett says if you cannot watch your portfolio lose 50 percent of its value without becoming panic-stricken, you shouldn't be in the market. Well, according to that criterion, most of us should think very hard before investing in stocks. Although perhaps not panic-stricken, most of us would be deeply perturbed if our portfolio lost half its value. For the majority of us, the money we're putting into stocks is hard earned. To watch it disappear is distressing. The distress can result in small investors selling fundamentally sound stocks just before they recover. Unfortunately, people read books about investing like Buffett and convince themselves that they will be able to handle the stress of watching their stocks dropping in value. It's only when it really happens to them that they learn the truth - watching your stocks sink is extremely stressful and, after holding underperforming stocks for a long time, people sometimes do end up selling at a big loss.
Small investors fail because they do not have Warren Buffett's genes. Buffett is an unparalleled genius who has thought deeply about investment for decades. Although he talks modestly and in homely tones to the public, he is an extremely clever and competitive man with an enormous capacity to memorize numbers and facts and apply them in financial calculations and in due diligence. He has developed an immense array of strategies and tactics to keep his wealth increasing, irrespective of market conditions. You should no more think you might emulate Warren Buffett after reading a few books than you should believe that by studying physics for a few months in your spare time, you might emulate Albert Einstein or Isaac Newton.
Warren Buffett's methods are appropriate for experienced investors who share his temperament. New investors may enjoy greater success using less challenging methods.