WALL STREET DAILY

INVEST LIKE BUFFET - HOW HE DOES IT

Wall Street Daily Letter

 

How to Invest Like Warren Buffett

Warren Buffett, aka the Oracle of Omaha, one of the most recognized and most successful investors of all time, has made billions of dollars in his lifetime for Berkshire Hathaway (NYSE: BRK.B) shareholders-and himself.

But Buffett isn't some macho hedge-fund big shot taking huge gambles that make (and lose) fortunes overnight. He has reaped billions by making a lot of smart bets over the years. His success hinges on three characteristics: patience, discipline, and risk aversion.

Sure, that combination isn't some magic elixir. Heck, it doesn't even sound all that exciting. But Mr. Buffett's net worth of around $85 billion says that it works.

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You see, movies and TV about the stock market usually take a lot of artistic liberties. They dramatize and exaggerate what happens on Wall Street. Yes, wild stuff does happen and some folks do crave action and risk millions of dollars a minute. However, no one can be consistently successful over the long run without at least one of the three characteristics followed by Buffett.

Let's take a look at those three keys to success, one by one.

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Patience

There are few feelings better than making a trade and within days generated a huge amount of money. Ask yourself though, how often does that happen? You may get lucky a few times, maybe even more than that. But you can also get unlucky, when a trade could immediately backfire and reduce your gains from the successful trades.

If you're able to consistently generate huge returns in a short amount of time, count yourself in the small minority. You are either extremely lucky or you know a great trading strategy.

For others, patience is a crucial quality. It's the understanding that investing requires diligent research and analysis to find quality assets, and then allowing the asset time to rise in value.

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Discipline

In short, discipline is about forming good investing habits and sticking to them. Abiding by a clear set of rules helps you make rational investment decisions. Discipline keeps you grounded.

For example, let's say you carefully researched company XYZ and you really like its stock so you bought some shares. But then the market starts to fall. To make it worse, that company reports a disappointing quarter and lowers its revenue and earnings guidance, which causes the stock to fall 15% overnight.

It's all too easy to let emotions get the best of you in this situation and sell first then ask questions later. A disciplined investor, however, will analyze as much information as he can before he makes a decision and he will stick to his rules.

Some examples of questions he might ask himself are: Given new available information, does the stock still fit my investment criteria? If I am using a soft stop loss strategy, has the stock price passed the threshold? If I sell the stock, what other moves do I have to make to rebalance my portfolio to suit my long-term goals?

Discipline doesn't mean stubbornly holding onto a stock no matter what. Rather, a disciplined investor tries to avoid acting impulsively. He tries to make his decision based on rational factors. If the company had a bad quarter because of temporary factors, the stock will likely recover. But if the bad quarter was caused by more serious, longer-lasting headwinds, there's nothing wrong with moving on.


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Risk Aversion

When you see "risk aversion," you may think Buffett recommends avoiding stocks with high volatility-ups and downs-but that's not the case. His definition of "risk" is as a dictionary may define the term: the possibility of loss or injury.

Buffett doesn't really care how much an asset price fluctuates. As long as he thinks he's buying an asset (stock, company, etc.) at a low price relative to the intrinsic value, he is happy. Think of the intrinsic value as an asset's "true" value, determined through fundamental analysis.

In contrast, the market price of an asset is set by buyers and sellers, so it can deviate by a lot from the intrinsic value in the short term. But over the long term, the market price tends to (but not always) move toward the intrinsic value. The idea is that if you buy an undervalued asset, you will benefit from both this move and (hopefully) an increase in the intrinsic value.

Note that Buffett isn't looking to just buy something cheap. He is looking to buy something that is undervalued. After all, paying next to nothing for something that will be worthless in a year is still a bad investment.

So to Buffett, risk aversion is a matter of buying quality assets at as large a discount as possible. It's no surprise, then, that Buffett is known to be a value investor.

To Buffett, risk is deterioration in the underlying intrinsic value. Market price volatility to him is not necessarily a bad thing, because it creates buying opportunity when a quality asset drops in price.

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Putting it All Together

Of course, most people aren't Warren Buffett. However, the basic lessons to learn from him can benefit every investor: Have clear investment strategies and goals in mind. Be disciplined and stick to those strategies and allow time for those strategies to work. Distinguish between market price and intrinsic value. Identify undervalued assets. If you are invested in quality assets for the long haul, do not overreact to the market in the short term but continue to reevaluate your investments.