Business Advice
is your arsenal for developing and maintaining sound financial plans and business strategy.
Inside: Budgeting | Compensation | Valuation
Free Trial: Intuit QuickBooks
Simple Start Free Edition 2009 for Windows
Departments
The Only Guide to Investing an Entrepreneur Will Ever Need by Lewis Schiff
Got a question? You can leave it in the comment section below, or — if you prefer privacy — you can email it to me at investingguide@inc.com. I'll only publish your question if you give me permission and only in a way that doesn't reveal your identity. Want to hear more about the principals behind this investing guide? Read our manifesto.
Recent Entries
Inc.com Featured Blogs
July 2, 2008
What Would Warren Buffett Do?
Posted at 10:30 AM
All around you, people are investing. They speculate in tiny companies with a good story, they put their money into global businesses with well known brand names, and at social occasions, they talk about these investments -- certainly their successes, occasionally their failures.
Perhaps you've collected an assortment of random stocks and some mutual funds, too. In addition to occasional bragging rights, this gives you something to watch on your portfolio list in the papers or on a Web site. On a good day, it can give you a boost and that alone can make it worth the money you've invested. On a bad day—which can stretch into a bad week or a bad month or worse—it can become an obsession and a way to relive a failure over and over and over again.
I've been talking to investors for more than 10 years, and most of them don't even understand what game they're playing, let alone the rules of the game. In a famous book from the 1930s, entitled Where Are The Customers' Yachts?, the author, a former stock broker, observes that brokers always seem to do quite well, accumulating toys and other symbols of success, while the clients (or "customers" as they were known back then) don't seem to do nearly so well. Flash forward 70 years, and nothing has changed. Study after study demonstrates that individuals fare poorly as investors.
My guess is, you're no different. There's only one Warren Buffett. If you want to buy a share of his company, Berkshire Hathaway, it's available to you. As of this writing, it's priced at $120,000 per share. Sound like a lot? Maybe it is, maybe it isn't. I've probably given this advice to go buy Berkshire Hathaway, dozens of times. When I started, a decade and a half* ago, shares of Berkshire Hathaway went for about $9,000 a share. People said "that's expensive," back then, too. They also said, "does he still have the gift?" and "Is he going to retire?" Those were all legitimate questions back then, and they are still. I wish I knew the answers. But just as I don't know what's going on in the mind of the latest CEO who's projected to save America's economy, I also don't know what's inside Warren Buffett's head. I never have. And I never will.
I do, however, understand how to make money in the stock market. Throughout history, great investors, including Warren Buffet, have told us the secret to successful investing. Only a fraction of us have followed it. The secret is diversification. Here's what you might be thinking right now: But I do diversify already. I own 15 different tech stocks. Or, I own 10 different mutual funds. Or, I have three different financial advisors managing my money.
None of this is true diversification. Diversification is mostly science and a little bit of art. Economists have won Nobel prizes for helping us understand diversification. They speak about modern portfolio theory, efficient frontiers, and asset allocation. Diversification is complicated stuff.
What most people do is spread their money out and think they've diversified. In fact, diversification comes down to a simple premise called "non-correlating markets." Here's a simple example: You own shares in two companies. One's a sun tan lotion company and the other is an umbrella company. That's a well-executed diversification plan because you own shares in companies that do well in different weather situations. As a result, you've got a way to make money whether it rains or shines. Unfortunately, the world's a lot more complicated than that example and you can't intuitively diversify your money. It takes sophisticated models to truly diversify. But the demand for diversification has been so great from the institutional investors—such as pension funds and endowments—that a slew of powerful tools have been created to develop more accessible models. And a few pioneers, like John Bogle, founder of Vanguard and the eponymous founder of Charles Schwab, have made it their lives' work (along with their lives' fortunes) to bring these tools to you.
As complicated as it is, diversification can be had today with a single mouse click. It's simple, elegant, and there for the taking. You may have heard about index funds or "passive investing." These are related to diversification, and they are an investor's best friends. Even Warren Buffett believes in them. In fact, he recently placed a million-dollar bet that an index fund based on the S&P 500 would outperform a collection of hedge funds. Embracing diversification is at the heart of this blog. To learn more about it, check out our mission statement.
* This sentence was incorrect when first published.
Got a question? Please send it to me at investingguide@inc.com.
Try a RISK-FREE Issue of Inc. Today!
Select Services
- Home |
- Contact Us |
- About Us |
- Subscribe |
- Advertise Online |
- Legal Disclaimers |
- Media Kits |
- Press |
- Privacy Statement
Copyright © 2009 Mansueto Ventures LLC. All rights reserved. Inc.com, 7 World Trade Center, New York, NY 10007-2195
Mansueto Digital Network: Inc.com | FastCompany.com | IncBizNet.com | IncTechnology.com | FastCompany.tv
I always read that Warren Buffett would rather put his eggs in a few baskets that have long-term growth potential and then watch them closely rather than put his eggs in lots of baskets, hoping the winners make enough to outdo the losers.
Don't most people think of diversification as "put your eggs in lots of baskets"?
I prefer to carefully select stocks that I think are long-term winners and put my money in those (based mainly on what I can gather about how Buffett analyses companies).
You're describing "concentrated portfolios." These portfolios, with fewer stocks in them, will rise faster when the stocks are doing well, and plummet faster when they're doing badly. This represents a classic "beat the market" strategy.
Part of the reason why these rarely work is that, while on an annualized basis, they may outperform an index fund strategy, their increased volatility acts as a drag on the cash value.
In other words, a concentrated stock portfolio that goes up and down a lot but has an annualized return of 11% could actually end up with less cash in it than a less volatile (more diversified) portfolio that has a 10% annualized rate of return.
Of course, if all your stock choices are winners and outperform the market, then none of this matters and you're the next Warren Buffett. If that's the case, I'll send you my retirement portfolio and you can turn me into a "Mullings-aire."
Great post. Thanks for the idea.
I have to agree with David's comment on the diversification issue. I was at the Berkshire Hathaway Shareholder meeting this year and listened to Charlie Munger and Warren Buffett say diversification is for "know nothing" investors and makes no sense for a skilled investor. They recommended finding a few great businesses and investing heavily in them. For "know nothing" investors they recommended a low cost index fund that tracks American businesses.
BRK stock was a heck of lot more than $9,000 a decade ago!
As the previous poster reported, Buffett has said for years that diversified portfolios are for the uninformed investor, and even then, he still does not recommend it. Per Buffett, invest in what you know and understand.
I am an investor in DFA funds offered by IFA Financial Advisors. Both DFA and IFA (who offer DFA Funds)have their funds with exceptionally low expense charges, invest only in Index funds, believe only in passive investing and the funds are run by and advice given regarding the companies that are invested in, by academia rather than active mutual fund managers. They have 20 different portfolios, totally structured towards one's approach to risk & return and they have excellent diversification in many different asset classes. I am invested in Portfolio 80 which has 17,000 positions and is invested in over 40 countries. Your article was excellent Lewis and my investment philosophy matches yours to a " T ". I only wish everyone would seriously take a look at it, as well as the www.ifa.com website. The site contains the most comprehensive financial databases I have ever seen and has a wealth of information for serious investors. The art illustrations are excellent as well.
Brison and Michael Rogers make excellent points about the differences between "skilled" investors and "uninformed" investors. If you are going to use these labels, keep in mind that most so-called "uninformed" investors out-perform so-called "skilled" investors. That's because there are very few Warren Buffets out there. But even if you are going to go for the Buffett "brass ring," consider a blended portfolio:
CORE: A diversified index fund portfolio. More than 50%, up to 90% of your portfolio.
EXPLORE: a concentrated portfolio (between 10% and less than 50%).
That will moderate the effects of the "explore" portfolio while providing some downside risk mitigation.
Steve,
I, too, am a huge fan of DFA funds. If anyone is looking for more info about DFA funds, the most sophisticated "index funds" on the market, send me an email (investingguide@mvpub.com) or post a comment here.
This is just poor journalism. The article is called what would warren buffet do but what you really meant is ..."Hey I'm gonna drop Warren Buffets name, and what I think constitutes a good portfolio then blend 'em all together so that people will believe them....brilliant!!" Yes, diversification is often thought of as a good thing, but not by warren buffet. ...and inc. I'm disappointed, you could have at least told us who wrote the article so that we can avoid his stuff in the future.
I agree with the previous poster, but I don't agree that this is journalism as journalism implies some fact checking. The author knows nothing about how Warren Buffett invests. The article has merits for us know-nothing investors, but Buffett would not do anything like the author implies.
Fact check #1. On July 2, 1998, exactly a decade before this article was published, BRK.A closed at 77,500 not 9,000. More than a small error there.
Fact check #2. Buffett is known to have made his fortune holding only 5 to 10 stocks at a time, and he put 30% or more of his portfolio in only one stock. He believes diversification hurts returns and is something people do to protect against their own stupidity.
Fact check #3. Buffett's argument on the bet with a hedge fund has nothing to do with diversification but with costs. His argument is that the extra returns that the hedge funds generate can't make up for the onerous fees they charge (20%+).
This guy is just a salesman selling Modern Portfolio Theory. I would ask only one question how would you feeel if you invested in "the index" from 66-82 and only produced a return under 2%. That is total return. This could be the market we are in today.
Correction on my statement about when Berkshire Hathaway was trading in the $9,000 range. I said it was "a decade ago." I guess I'm losing track of time because it was a decade and a half ago. (end of 1992).
What we view as tough times may soon be viewed as "buying opportunities" for Warren Buffett and other value investors. After all, some of their best purchases were made during the stagflationary period of the 1970's.
I think Buffett and Munger invented an amazing Behavioral Finance Formula or Process that is underappreciated by the business and academic communities. On paper as early as the 1977 BRK annual letter, their work in designing a mixed qualitative + quantitative formula may be worthy of a Nobel Prize in Economics and Behavioral Finance. So, in my new self-published book "The Four Filters Invention of Warren Buffett and Charlie Munger" ( www.frips.com ) I examine each of the basic steps they perform in "framing and making" an investment decision. I made this book a small and focused look into this amazing invention within "Behavioral Finance."
Buffett mentions the Four Filters this way: "Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag."
In my view, the genius of Buffett and Munger's four filters process was to "capture all the important stakeholders" in one "multi-variable" equation. Imagine...Products, Enduring Customers, Managers, and Margin-of-Safety... all the important stakeholders for business success in one mixed "qual + quant" formula...The genius of the Munger and Buffett collaboration. And, quality bargains at 50 cents on the dollar may soon appear; Use the Four Filters!
Here is a 10 minute audio book summary: http://www.frips.com/4fsummary.mp3
Post Your Own Comments