Not doing well in your investments? Warren Buffett will teach you how to invest

Are you investments going nowhere?

Do you feel like your investing returns are going nowhere? It is not a personal issue. Many people simply have not learnt how to invest, but are already buying stocks.

To invest successfully, you have to know how to invest. Who is a better teacher than the best investor in the world? In this post, you will know more about these:

  • Who is Warren Buffett
  • How does Warren Buffett invest
  • How he wants you to invest
  • How should you invest

Who is Warren Buffett?

Most people know him even though they don't know how to invest. Warren Buffett is widely regarded as the world's best investor. He was once the world's richest man, and the only person in history to make it to the world's top 10 richest persons list through the stock market.

He has managed an annual investment rate of return of 22.3%, and his company, Berkshire Hathaway, has grown 6,952 times since 1964. Be careful when someone claims that he or she can easily beat this rate of return.

How does he invest

Many people have heard of how he invests, but don't know exactly how. People call him a value investor, but he has admitted that he is a mix between a qualitative investor and a quantitative investor.

When he was first starting out at Berkshire Hathaway, which is his investment company, he used more of a quantitiative approach. He ascribed his method to Benjamin Graham, who is also known as the father of Value Investing.

Benjamin Graham was famous for his Mr Market analogy. Mr Market is someone who is a maniac; on some days, he would be very happy, and would sell stocks to you at a high price. On other days, he would be depressed, and would offer stocks to you at absolutely low prices.

Stock market investing

Mr Market meant to symbolise the stock market. The stock prices of companies would move daily, sometimes at extravagant rates, but nothing fundamental about the company has changed. The company is essentially the same.

Thus, one can simply buy good companies at depressed prices and hold them till the market realises their value.

Using Benjamin Graham's method, Buffett would source for companies which are below book value, and often also traded at a deep discount to book value. Often, the companies he acquired were small and illiquid, but also under the radar of analyst.

Here are the metrics that Benjamin Graham outlined:

  • An earnings-to-price yield at of least twice the AAA bond rate
  • Price-earnings ratio less than 40% of the highest price-earnings ratio the stock had over the past 5 years
  • Dividend yield of at least 2/3 the AAA bond yield
  • Stock price below 2/3 of tangible book value per share
  • Stock price below 2/3 of Net Current Asset Value
  • Total debt less than book value
  • Current ration greater than 2
  • Total debt less than 2 times Net Current Asset Value
  • Earnings growth of prior 10 years at least at 7% annual compounded rate
  • Stability of growth of earnings in that no more than 2 declines of 5% or more in year end earnings in the prior 10 years are permissible

The AAA bond rate can be taken as the risk-free rate in today's terms, which the 10-year government bond is a good proxy for. 

When analysts start to uncover the undervalued companies that Buffett has already acquired, their stock price skyrockets, giving a huge return on investment for Buffett.

This strategy was good for Buffett, but he wanted to make it better. As Berkshire Hathaway grew in size, they could no longer acquire small companies without acquiring the entire company. Buffett preferred to remain a silent investor.

Due to this, Buffett learned from Philip Fisher. Fisher was more qualitative tha quantitative, focusing on management integrity and abilities. Such an approach led Buffett to invest in companies such as Coca-Cola.

Besides management, Buffett would also look at other qualitative factors. Because he would like to buy a company and hold it forever, he has to make sure that the company he buys has a sustainable advantage over competitors that competitors are unable to emulate nor will the industry make it obsolete.

Further readings:
Using economic analysis for a top-down approach
Doing an industry and business analysis

The investing styles of Graham and Fisher can be summed up easily. Graham wants to buy undervalued companies, which are companies which are cheap. Fisher wants to buy good companies, regardless of their prices.

For Buffett, he wants to buy good companies which are cheap. However, he also cautions. He says that, "It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price".

Buffett often says that he investing is simple but not easy. It is simple to buy undervalued companies but not easy to find them. To many investors, Buffett actually tells them another way to invest.

How he wants you to invest

If the world's best investor wants to teach you how to invest, do you want to listen? Warren Buffett has consistently taught the world how to invest, and he does it through Berkshire Hathaway's annual reports. The annual reports have even been analysed, categorised, and compiled into a book.

In his 2013 letter to shareholders, Buffet actually talks about how he would invest, for his wife.

Warren Buffet 2013 Shareholders Letter

What I advise here is essentially identical to certain instructions I’ve laid out in my will. One bequest provides that cash will be delivered to a trustee for my wife’s benefit… My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors…

If he wants to invest this way for his wife, it probably is the best way to invest for all of us. In the same letter, he also says this.

Both individuals and institutions will constantly be urged to be active by those who profit from giving advice or effecting transactions. The resulting frictional costs can be huge and, for investors in aggregate, devoid of benefit. So ignore the chatter, keep your costs minimal, and invest in stocks as you would in a farm.

He says this because he is very aware of the biases that us humans have, especially when we deal with the stock market (although females are marginally better investors than man). Just take a look at this finding.

Peter Lynch is a legendary investor and fund manager of the Fidelity Magellan Fund from 1977 to 1990. During his tenure, the annual return of the fund was 29%. Given that, you would have expected investors in his fund to make enormous returns during this period. However, the average investor actually lost money.

We like to do many things that diminish our returns. However, it is not our fault, our brains are wired this way:

  • Loss aversion
  • Fear and greed
  • Performance chasing
  • Casino investing

Loss aversion
Investors are likely to sell too early when the stock rises, and hold on too late when the stock falls. This has got to do with Prospect Theory. We value losses more than we value gains. If a stock falls by $1, we are more unhappy than we would be happy if the stock had risen by $1. This is also known as Loss Aversion.

As a result, we do not want to sell our loss-making stocks, because that would mean a realisation of losses, which is something we would like to avoid.

Fear and greed

We are equally bounded by fear and greed. When the stock market is doing well, we are excited, and buy stocks at the peak, hoping they will move higher and make us money. When the stock market does poorly, we sell our stocks in the fear that the stock prices will drop further, often leading to us selling at the troughs.

Performance chasing
Although past history is not indicated of future performance, investors like to chase performance. They buy stocks which have risen the most in the past one year, on the expectation that they will continue to do so. However, nothing is further from the truth.

Because of Mean Reversion, top performing stocks tend to perform worse next year. On the other hand, the worst performing stocks perform better the following year. This then leads to investors who chase performance not being able to get a satisfactory investment return.

In this post, less than a quarter of top performing funds were still on top the next year. Funds that do in one year fall behind the next year. Simply chasing the best performing ones would lead to poor investment returns.

Casino investing
Some people take investing as gambling. They hear their friends talk about a certain stock, and then they buy it. They look around and find that the stock is a household name, and think that it will do well. However, they do not check the valuation of the company and end up making poor returns.

They base their decisions on hot tips, which are often purchases of penny stocks, which they think is cheap. These penny stocks end up going bankrupt in the end. Not only did the investors not get any return from their investments, they even lost their capital.

Buffett and the cognitive biases

Warren Buffett understands all these cognitive biases. Basically, he is saying that a low-cost index fund will easily beat any investor over the long run. I agree with him. Don't be tempted by other so-called investment gurus, and stay the same course.

Further readings:
- 2013 Berkshire Hathaway Letter to Shareholders
- The case for index investing - a parable
- Why are individual investors so bad at investing?

Simply put your money, regularly, into a low-cost portfolio. I recommend the Boglehead inspired Singapore 3-fund portfolio. You would need to hold a domestic stock fund and an international stock fund, as well as an domestic bond fund.

Investing doesn't have to be complicated. The simplest method is often the best method.

How should you invest?

If the definition of a hypocrite is someone that says something but does another, then Warren Buffett would certainly fall into this definition. But, he being hypocritical is actually good for us.

Even though Buffett has made his riches through his own method of investing, he knows it is hard work. Furthermore, our cognitive biases prevent us from investing well. He is aware of this.

So, Buffett has long been an advocate of index investing. Simply buy into an index at regular intervals, and forget about it. Humans tend to trade too often, and diminish their own returns.

If you think that you have both the time to do research and the ability to be patient and wait for a very long time until the market realises the true value of your investments, then value investing is for you. Sadly, majority of us do not the time or the temperament needed. Then, index investing would be a better investment style. After all, even Warren Buffett himself recommends it.

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