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 10 buckets of investment tips given by Warren Buffett below.
By remembering Buffett’s advice about investing, people can avoid some of the common mistakes that hurt returns and put their financial goals at risk.
Each piece of advice has at least one Warren Buffett quote to support it, and it 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 to get involved in investments that are overly complex. Many of us have spent our entire careers working in no more than a handful of different industries.
We probably have a reasonably strong grasp on how these particular markets work and who the best companies are in the space. But the vast majority of publicly traded companies work in fields that we know very little or nothing about.
“Never invest in a business you cannot understand.” Warren Buffett
This doesn’t mean we can’t invest capital in these areas of the market, but we should approach them with caution.
I think that most companies run businesses that are too complicated for me to easily understand. I’ll be the first to tell you that I can’t tell how well a biotechnology company’s drug pipeline will do, what the next big trend in teen clothes will be, or what the next big technological breakthrough will be that will make the semiconductor chip industry grow.
These kinds of complicated problems have a big effect on the profits of many companies on the market, but they are hard to predict. 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 get a reasonable understanding of 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:
It’s easy to say “no” to businesses and industries that are too complicated, but it’s much harder to find businesses that are good.
Warren Buffett’s investment strategy has changed a lot over the last 50 years. Now, he almost always buys high-quality companies that have long-term growth prospects. 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 thought that if you bought a stock at a low enough price, something good would happen out of the blue that would let you sell it at a decent profit, even if the company’s long-term performance was still bad.
With more years of experience under his belt, 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 will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces. These types of 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 that I use to gauge business quality is 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.” 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 purchased at a reasonable price, for 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 clearly embraces a buy-and-hold mentality. He has held some of his positions for a number of 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. Just like Warren Buffett said, time is the friend of a wonderful business. 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 to “buy right and sit tight.”
“The stock market is designed to transfer money from the active to the patient.” Warren Buffett
4. Diversification can be dangerous.
In my view, individual investors gain most of the benefits of diversification when they own between 20 and 60 stocks across a number of different industries.
However, many mutual funds own hundreds of stocks in a portfolio. Warren Buffett is the exact opposite. Back in 1960, Buffett’s largest position was a whopping 35% of his entire portfolio!
Simply put, 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 major 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) an attractive purchase price when measured against the yardstick of value to a private owner; and (4) an industry with which we are familiar and whose long-term business characteristics we feel competent to judge.
It is difficult to find investments meeting such a test, and that is one reason for our concentration of holdings. We simply can’t find one hundred different securities that conform to our investment requirements. However, we feel quite comfortable concentrating our holdings in the much smaller number that we do 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 as well.” 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 most common misconceptions about investing is that only smart people can pick stocks that do well. However, raw intelligence is arguably one of the least 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
Warren Buffett’s investment philosophy doesn’t have to be understood by a genius, but it is incredibly hard for anyone to consistently beat the market and avoid making behavioral mistakes.
Equally important, investors must remain aware that there is no such thing as a 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 need to know the difference between price and value and focus on high-quality companies that are trading at the best prices right now.
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 of time.
Investing is not meant to be exciting, and dividend growth investing in particular is a conservative strategy. Rather than try to find the next major winner in an emerging industry, it is often better to invest in companies that have already proven their worth.
“We make no 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 the course of 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—and 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. Even though Warren Buffett is one of the best stock pickers of all time, if not the best, his 2013 shareholder letter argues for passive index funds.
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.
Warren Buffett talks a lot about how important it is to only invest in companies with management teams that you can trust and that are good at what they do.
Simply put, Warren Buffett is very careful 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 it doesn’t care about what’s best for owners, the price/value ratio of their stock (compared to other stocks) will be bad for a long time, no matter how sure management is that the action that lowered value was a one-time thing.” —Warren Buffett
Warren Buffett is obviously far more connected than any of us, which certainly 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!