Warren Buffett’s investment advice is timeless. I have lost track of the number of investing mistakes I have made over the years, but almost all of them fall into one of the ten buckets of investment tips given by Warren Buffett below.
By remembering Buffett’s advice about investing, people can avoid common mistakes that hurt returns and put their financial goals at risk.Each piece of advice is backed up by at least one quote from Warren Buffett and can help investors find safer stocks.Let’s dive in.
1. Invest in what you know…and nothing more:
One of the easiest ways to make an avoidable mistake is by getting involved in overly complex investments. Many of us have spent our entire careers working in a handful of different industries.
We probably have a reasonably firm grasp on how these particular markets work and who the best companies are in the space. However, the majority of publicly traded companies participate in industries in which we have little to no direct experience.
“Never invest in a business you cannot understand.” Warren Buffett This doesn’t mean we can’t invest capital in these market areas, but we should approach them cautiously.
In my view, most companies operate businesses that are too difficult for me to understand comfortably. I’ll be the first to tell you that I cannot forecast the success of a biotechnology company’s drug pipeline, predict the next major fashion trend in teen apparel, or identify the next technological breakthrough that will drive growth in semiconductor chips.
These complex issues materially affect the earnings generated by many companies in the market but are arguably unforecastable. When I come across such a business, my response is simple: “Pass.”
There are too many fish in the sea to get hung up on studying a company or industry that is just too hard to understand. That is why Warren Buffett has historically avoided investing in the technology sector. If I cannot understand how a company makes money and the main drivers that impact its industry within 10 minutes, I move on to the next idea.
2. Never compromise on business quality:
While saying “no” to complicated businesses and industries is pretty straightforward, identifying high-quality companies is much more challenging.
Warren Buffett’s investment philosophy has evolved over the last 50 years to focus almost exclusively on buying high-quality companies with promising long-term opportunities for continued growth. Some investors might be surprised to learn that the name Berkshire Hathaway comes from one of Buffett’s worst investments.
Berkshire was in the textile manufacturing industry, and Buffett was enticed to buy the business because the price looked cheap. He believed that if you bought a stock at a sufficiently low price, there would usually be some unexpected good news that would give you a chance to unload the position at a decent profit—even if the long-term performance of the business remains terrible.
With more years of experience, Warren Buffett changed his stance on “cigar-box” investing. He said that unless you are a liquidator, that kind of approach to buying businesses is foolish.
The original “bargain” price probably won’t be such a steal after all. In a tricky business, no sooner is one problem solved than another one surfaces. These companies also usually earn low returns, further eroding the initial investment’s value. These insights led Buffett to coin the following well-known quote:
“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” Warren Buffett
One of the most important financial ratios I use to gauge business quality is the return on invested capital. Companies that earn high returns on the capital tied up in their business have the potential to compound their earnings faster than lower-returning businesses. As a result, the intrinsic value of these enterprises rises over time.
“Time is the friend of the wonderful business, the enemy of the mediocre,” said Warren Buffett.
High returns on capital create value and are often indicative of an economic moat. I prefer to invest in companies that generate high (10–20%) and stable returns on invested capital. Instead of giving in to the temptation to buy a dividend stock yielding 10% or snap up shares of a company trading for “just” 8x earnings, be sure you are comfortable with the company’s business quality.
3. When you buy a stock, plan to hold it forever.
Once a high-quality business has been reasonably purchased, how long should it be held? “If you aren’t thinking about owning a stock for ten years, don’t even think about owning it for ten minutes.” Warren Buffett “Our favorite holding period is forever.” Warren Buffett
Warren Buffett embraces a buy-and-hold mentality. He has held some of his positions for several decades. Why? For one thing, it’s hard to find excellent businesses that continue to have a bright long-term future (Buffett runs a concentrated portfolio for this reason). Furthermore, quality businesses earn high returns and increase in value over time. As Warren Buffett said, time is the friend of a beautiful company. Fundamentals can take years to impact a stock’s price, and only patient investors are rewarded.
Finally, trading activity is the enemy of investment returns. Constantly buying and selling stocks eats away at returns in the form of taxes and trading commissions. Instead, we are generally better off “buying right and sitting tight.” “The stock market is designed to transfer money from the active to the patient.” Warren Buffett
4. Diversification can be dangerous:
I believe individual investors gain most of the benefits of diversification when they own between 20 and 60 stocks across several industries. However, many mutual funds own hundreds of stocks in a portfolio. Warren Buffett is the exact opposite. In 1960, Buffett’s most prominent position was a whopping 35% of his entire portfolio!
Warren Buffett invests with conviction in his best ideas and realizes that the market rarely offers up great companies at reasonable prices. “You will notice that our significant equity holdings are relatively few. We select such investments on a long-term basis, weighing the same factors as would be involved in the purchase of 100% of an operating business: (1) favorable long-term economic characteristics; (2) competent and honest management;
(3) a purchase price that is attractive when measured against the yardstick of value to a private owner; (4) an industry with which we are familiar and whose long-term business characteristics we feel competent to judge. It isn’t easy to find investments meeting such a test, which is one reason for our concentration of holdings.
We can’t find one hundred different securities that conform to our investment requirements. However, we feel comfortable concentrating our holdings in a much smaller number than we identify as attractive.” Warren Buffett When such an opportunity arises, he pounces.
“Opportunities come infrequently. When it rains gold, put out the buck, not the thimble.” Warren Buffett
5. Most news is noise, not news:
There is no shortage of financial news hitting my inbox each day. While I am a notorious headline reader, I brush off almost all of the information pushed my way. The 80/20 rule claims that around 80% of outcomes can be attributed to 20% of the causes of an event. When it comes to financial news, I would argue it’s more like the 99-1 rule: 99% of the investment actions we take should be attributed to just 1% of the financial news we consume.
Most of the news headlines and conversations on TV are there to generate buzz and trigger our emotions to do something—anything! “Owners of stocks, however, too often let the capricious and often irrational behavior of their fellow owners cause them to behave irrationally. Because there is so much chatter about markets, the economy, interest rates, the price behavior of stocks, etc., some investors believe it is important to listen to pundits—and, worse yet, to consider acting upon their comments.” Warren Buffett
6. Investing isn’t rocket science, but there is no “easy button”:
One of the greatest misconceptions about investing is that only sophisticated people can pick stocks successfully. However, raw intelligence is arguably one of the minor predictive factors of investment success.
“You don’t need to be a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ.” Warren Buffett
It doesn’t take a genius to follow Warren Buffett’s investment philosophy, but it is tough for anyone to consistently beat the market and sidestep behavioral mistakes.
Equally important, investors must remain aware that there is no magical set of rules, a formula, or an “easy button” that can generate market-beating results. It doesn’t exist and never will.
“Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the models. Beware of geeks bearing formulas.” Warren Buffett
7. Know the difference between price and value:
Stock prices are pushed at us nonstop. For some reason, investors love to fixate on ticker quotes running across the screen. “Price is what you pay. Value is what you get.” Warren Buffett “The stock market is filled with individuals who know the price of everything but the value of nothing.” Phil Fisher Investors must distinguish between price and value, concentrating their efforts on high-quality companies trading at the most reasonable prices today.
8. The best moves are usually boring:
Investing in the stock market is not a path to getting rich quickly. If anything, I believe the stock market is best meant to moderately grow our existing capital over long periods.
Investing is not meant to be exciting, and dividend growth investing is a conservative strategy. Rather than find the next major winner in an emerging industry, it is often better to invest in companies that have already proven their worth. “We do not attempt to pick the few winners that will emerge from an ocean of unproven enterprises. We’re not smart enough to do that, and we know it.” Warren Buffett
After all, the goal is to find quality businesses that will compound in value over many years. If we get this right, our portfolio’s return will take care of itself.
9. Low-cost index funds are sensible for most investors:
Did you know that most investors fail to beat the market—often by a wide margin? We hurt our performance in many different ways—trying to time the market, taking excessive risks, trading on emotions, venturing outside our circle of competence, and more. Even worse, many actively managed investment funds charge excessive fees that eat away at returns and dividend income. Despite his status as arguably the most prolific stock picker of all time, Warren Buffett advocates for passive index funds in his 2013 shareholder letter.
Once Buffett passes away and his Berkshire Hathaway shares are given to charity, Buffett’s trustee has clear instructions to follow: “My advice to the trustee couldn’t 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—whether pension funds, institutions, or individuals—who employ high-fee managers.” Warren Buffett
10. Only listen to those you know and trust.
Throughout his shareholder letters and occasional interviews, Warren Buffett emphasizes the importance of only investing in trustworthy, competent management teams. Simply put, Warren Buffett is cautious when it comes to selecting his business partners and managers. Their actions can make or break an investment for many years to come.
“Once management shows itself insensitive to the interests of owners, shareholders will suffer a long time from the price/value ratio afforded their stock (relative to other stocks), no matter what assurances management gives that the value-diluting action taken was a one-of-a-kind event.” Warren Buffett
Warren Buffett is far more connected than any of us, which helps him learn who the best and most trustworthy management teams are in a particular industry. “Management changes, like marital changes, are painful, time-consuming, and chancy.” Warren Buffett Be careful who you trust!