One of the easiest ways to make an avoidable mistake is getting 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.
However, the far majority of publicly-traded companies participate in industries we have little to no direct experience in.
“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 with caution.
In my view, the far majority of companies operate businesses that are too difficult for me to comfortably understand. I’ll be the first one 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 types of 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.
While saying “no” to complicated businesses and industries is fairly straightforward, identifying high quality businesses 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.
He believed that if you bought a stock at a sufficiently low price, there will usually be some unexpected good news that gives you a chance to unload the position at a decent profit – even if the long-term performance of the business remains terrible.
“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
3. When you buy a stock, plan to hold it forever
Once a high quality business has been purchased at a reasonable price, 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
“If the job has been correctly done when a common stock is purchased, the time to sell is almost never.” – Phil Fisher
Warren Buffett clearly embraces a buy-and-hold mentality. He has held some of his positions for a number of decades.
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
“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) purchase price attractive 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
On the other end of the spectrum, some investors excessively diversify their portfolios out of fear and/or ignorance. Owning 100 stocks makes it virtually impossible for an investor to keep tabs on current events impacting their companies.
Excessive diversification also means that a portfolio is likely invested in a number of mediocre businesses, diluting the impact from its high quality holdings.
“Diversification is a protection against ignorance. It makes very little sense for those who know what they’re doing.” – Warren Buffett
Perhaps Charlie Munger summed it up best:
“The idea of excessive diversification is madness.” – Charlie Munger
How many stocks do you own? If the answer is more than 60, you might seriously consider slimming down your portfolio to focus on your highest quality holdings.
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 for 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, price behavior of stocks, etc., some investors believe it is important to listen to pundits – and, worse yet, important to consider acting upon their comments.” – Warren Buffett
The companies I focus on investing in have thus far withstood the test of time. Many have been in business for more than 100 years and faced virtually every unexpected challenge imaginable.
Imagine how many pieces of gloom-and-doom “news” originated over their corporate lives. However, they are still standing.
Does it really matter if Coca-Cola missed quarterly earnings estimates by 4%?
Should I sell my position in Johnson & Johnson because the stock has slid by 10% since my initial purchase?
With falling oil prices lowering Exxon Mobil’s profits, should I sell my shares?
The answer to these questions is almost always a resounding “no,” but stock prices can move significantly as these matters arise. Financial news outlets also need to blow up these issues to remain in business.
“Remember that the stock market is a manic depressive.” – Warren Buffett
As investors, we need to ask ourselves if a news item truly impacts our company’s long-term earnings power.
If the answer is no, we should probably do the opposite of whatever the market is doing (e.g. Coke falls by 4% on a disappointing earnings report caused by temporary factors – consider buying the stock).
6. Investing isn’t rocket science, but there is no “Easy Button”
Perhaps one of the greatest misconceptions about investing is that only sophisticated people can successfully pick stocks.
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
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
Anyone proclaiming to possess such a system for the sake of drumming up business is either very naive or no better than a snake oil salesman in my book. Beware of self-proclaimed “gurus” selling you a hands-off, rules-based system to investing. If such a system actually existed, the owner certainly wouldn’t have a need to sell books or subscriptions.
“It’s easier to fool people than to convince them that they have been fooled.” – Mark Twain
Adhering to an overarching set of investment principles is fine, but investing is still a difficult art that requires thinking and shouldn’t feel easy.
“It’s not supposed to be easy. Anyone who finds it easy is stupid.” – Charlie Munger
“The stock market is filled with individuals who know the price of everything but the value of nothing.” – Phil Fisher
However, stock prices are inherently more volatile than underlying business fundamentals (in most cases).
Many firms continued to strengthen their competitive advantages during the downturn and emerged from the crisis with even brighter futures.
In other words, a company’s stock price was (temporarily) separated from its underlying business value.
“During the extraordinary financial panic that occurred late in 2008, I never gave a thought to selling my farm or New York real estate, even though a severe recession was clearly brewing. And, if I had owned 100% of a solid business with good long-term prospects, it would have been foolish for me to even consider dumping it. So why would I have sold my stocks that were small participations in wonderful businesses? True, any one of them might eventually disappoint, but as a group they were certain to do well.” – Warren Buffett
As long-term investors, we need to heed Warren Buffett’s investment advice to buy quality when it is marked down in price.
“Price is what you pay. Value is what you get.” – Warren Buffett
Stock prices will swing with investor emotions, but that doesn’t mean a company’s future stream of cash flow has changed.
Investing in the stock market is not a path to get 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
“Beware the investment activity that produces applause; the great moves are usually greeted by yawns.” – Warren Buffett
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 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
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 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 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 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.
“We’ve long felt that the only value of stock forecasters is to make fortune tellers look good.” – Warren Buffett
In fact, most of the “experts” issuing advice are very average using everyday standards.
“Wall Street is the only place that people ride to in a Rolls Royce to get advice from those who take the subway.” – Warren Buffett
One of my missions with Simply Safe Dividends is to cut through the noise and gimmicks that have infiltrated the finance world.
I urge investors to stay focused on the facts, recognize the amount of randomness involved in investing, set realistic expectations, and stay the course.
No one cares about your nest egg more than you do, and investors relying on dividends in retirement do not get a second chance.
“Management changes, like marital changes, are painful, time-consuming, and chancy.” – Warren Buffett