Rule No.1: Never lose money.
Rule No.2: Never forget rule No.1.
'Safety first' is not something one would associate with the stock market. But the greatest and most successful investor of the 20th century, Warren Buffett popularly known as “Wizard of Omaha” exercised caution. Some of Buffett's key principles that made him successful are:
1. Keep it simple
“There seems to be some perverse human characteristic that likes to make easy things difficult. I don’t look to jump over seven foot bars. I look around for one foot bars that I can step over.”
Investing need not be complex. Keep it simple. Make a list of criteria to buy a stock, and stick to it. Just remember that stock price should not be the only criteria. Buy only those stocks which match your investing criteria. If no companies fit the bill, then stay in cash.
Once you buy the stock, do not follow the stock’s price movement on a day to day basis. You will just lose your sleep over it. Follow it at a regular interval which you are comfortable with, and see that the set of criteria still matches. If the stock no longer matches your criteria, sell the stock. Don’t makes excuses to stay in the investment. Remove emotion out of the equation. This is what Warren Buffett would do!
2. Investing within your circle of competence
“Risk comes from not knowing what you are doing. Why not invest your assets in the companies you really like?”
As an investor it is very important to stick to what one knows. It is impossible for one to know everything about every company. Buffett does not try to invest in companies whose business he does not understand. He sat on tens of billions of dollars of cash during the technology boom because he had no expertise in technology. This even though he is a close friend of Bill Gates! It is important that one does not give into temptation and understand his circle of competence, however small it might be.
3. Diversification: Buffett’s take on it.
“Wide diversification is only required when investors do not understand what they are doing.”
This again goes with Buffett’s philosophy of investing within one’s circle of competence. Diversification to avoid risk is not a great idea at all. Diversifying can in fact lead to loss of profits when money is spread across too many investments. As Buffett states “diversification is a hedge against our own ignorance. It makes very little sense for those who know what they are doing”. Being a successful investor requires rigor and discipline. If one cannot do either, then he is better off being a passive investor, and index funds would be a better choice for him. This is one principle where Buffett disagreed with his guru Benjamin Graham. Graham recommended diversification into various stocks and index funds for all retail investors. In fact, the two ended up not writing a book together on investing only because of this disagreement.
4. Be an Investor, Not a Trader
“Wall Street makes money on activity. You make money on inactivity.”
Most investors cannot resist the temptation to constantly buy and sell. This can be a drag on their profits as they do not take into consideration trading fee, and commissions on activity. These small amounts can add up to a significant sum! Also a trading mind-set means reacting to market news, and market sentiment at the moment. There are chances of making profits in the short-term, but it is always wiser to ignore short-term fluctuations and invest in a company whose fundamentals are strong, and hold it in spite of news which could have driven its price down temporarily. Like Buffett puts it “our favorite holding period is forever”
5. Leave a Margin of Safety
“When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And the same principle works in investing.”
The concept of “margin of safety” means that you buy an investment at a significant discount to its intrinsic value. Even if the value of the investment is only slightly higher than its intrinsic value, it is better to avoid it. This difference in the price can provide a cushion during bad times, by significantly reducing losses.
Warren Buffett has a simple and clean approach to investing. He cares for awesome well-managed businesses which are undervalued, and which he understands. He sticks to his investing principles. Follow his philosophy, and you may not become a millionaire, but you will definitely get good returns on your investment. Investing in the stock market is a long-term game. As Buffett famously says…
“Someone's sitting in the shade today because someone planted a tree a long time ago”.