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Think Like Warren Buffett

Think Like Warren Buffett

| On 12, Aug 2013

Warren Buffett

Warren Buffett (Photo credit: MarkGregory007)

Back in 1999, Robert G. Hagstrom wrote a book about the legendary investor Warren Buffett
entitled “The Warren Buffett Portfolio”. What’s so great about the
book, and what makes it different from the countless other books and
articles written about the “Oracle of Omaha“, is that it offers the reader valuable insight into how Buffett actually thinks about investments. In other words, the book delves into the psychological mindset that has made Buffett so fabulously wealthy.

Although investors could benefit from reading the entire book, we’ve
selected a bite-sized sampling of the tips and suggestions regarding the
investor mindset and ways to improve stock selection that will help you
get inside Buffett’s head.

1. Think of Stocks as a Business

Many investors think of stocks and the stock market in general as
nothing more than little pieces of paper being traded back and forth
among investors. This might help prevent investors from becoming too
emotional over a given position, but it doesn’t necessarily allow them
to make the best possible investment decisions.

That’s why Buffett has stated he believes stockholders should think of themselves as “part owners” of the business
in which they are investing. By thinking that way, both Hagstrom and
Buffett argue that investors will tend to avoid making off-the-cuff
investment decisions, and become more focused on the longer term.
Furthermore, longer-term “owners” tend to analyze situations in greater
detail, and then put a great deal of thought into buy and sell
decisions. Hagstrom says this increased thought and analysis tends to
lead to improved investment returns.

2. Increase the Size of Your Investment

While it rarely – if ever – makes sense for investors to “put all of
their eggs in one basket”, putting all your eggs in too many baskets may
not be a good thing either. Buffett contends that over-diversification can hamper returns
as much as a lack of diversification. That’s why he doesn’t invest in
mutual funds. It’s also why he prefers to make significant investments
in just a handful of companies.

Buffett is a firm believer that investors must first do their homework before investing in any security. But after that due diligence
process is completed, investors should feel comfortable enough to
dedicate a sizable portion of assets to that stock. They should also
feel comfortable in winnowing down their overall investment portfolio to
a handful of good companies with excellent growth prospects.

Buffett’s stance on taking time to properly allocate your funds is
furthered with his comment that it’s not just about the best company,
but how you feel about the company. If the best business you own
presents the least financial risk and has the most favorable long-term
prospects, why would you put money into your 20th favorite business
instead of adding money to the top choices?

3. Reduce Portfolio Turnover

Rapidly trading in and out of stocks can potentially make an individual a
lot of money, but according to Buffett, this trader is actually
hampering his or her investment returns. That’s because portfolio turnover increases the amount of taxes that must be paid on capital gains and boosts the total amount of commission dollars that must be paid in a given year.

The “Oracle” contends that what makes sense in business also makes sense
in stocks: An investor should ordinarily hold a small piece of an
outstanding business with the same tenacity that an owner would exhibit
if he owned all of that business.

Investors must think long term. By having that mindset, they can avoid
paying huge commission fees and lofty short-term capital gains taxes.
They’ll also be more apt to ride out any short-term fluctuations in the
business, and to ultimately reap the rewards of increased earnings
and/or dividends over time.

4. Develop Alternative Benchmarks

While stock prices may be the ultimate barometer of the success or
failure of a given investment choice, Buffett does not focus on this
metric. Instead, he analyzes and pores over the underlying economics of a
given business or group of businesses. If a company is doing what it
takes to grow itself on a profitable basis, then the share price will
ultimately take care of itself.

Successful investors must look at the companies they own and study their true earnings potential. If the fundamentals are solid and the company is enhancing shareholder value by generating consistent bottom-line growth, the share price, in the long term, should reflect that. (To learn how to judge fundamentals on your own, see What Are Fundamentals?)

5. Learn to Think in Probabilities

Bridge is a card game in which the most successful players are able to
judge mathematical probabilities to beat their opponents. Perhaps not
surprisingly, Buffett loves and actively plays the game, and he takes
the strategies beyond the game into the investing world.

Buffett suggests that investors focus on the economics of the companies
they own (in other words the underlying businesses), and then try to
weigh the probability that certain events will or will not transpire,
much like a Bridge player checks the probabilities of his opponents’
hands. He adds that by focusing on the economic aspect of the equation
and not the stock price, an investor will be more accurate in his or her
ability to judge probability.

Thinking in probabilities has its advantages. For example, an investor
that ponders the probability that a company will report a certain
earnings growth rate over a five- or 10-year period is much more apt to
ride out short-term fluctuations in the share price. By extension, this
means that his investment returns are likely to be superior, and that he
will also realize fewer transaction and/or capital gains costs.

6. Recognize the Psychological Aspects of Investing

Very simply, this means that individuals must understand that there is a
psychological mindset that the successful investor tends to have. More
specifically, the successful investor will focus on probabilities and
economic issues and let decisions be ruled by rational, as opposed to
emotional, thinking.

More than anything, investors’ own emotions can be their worst enemy.
Buffett contends that the key to overcoming emotions is being able to
retain your belief in the real fundamentals of the business, and don’t
get too concerned about the stock market.

Investors should realize that there is a certain psychological mindset that they should have if they want to be successful, and try to implement that mindset.

7. Ignore Market Forecasts

There is an old saying that the Dow “climbs a wall of worry”. In other
words, in spite of the negativity in the marketplace, and those who
perpetually contend that a recession is “just around the corner”, the
markets have fared quite well over time. Therefore, doomsayers should be

On the other side of the coin, just as many eternal optimists argue that
the stock market is headed perpetually higher. These should be ignored
as well.

In all this confusion, Buffett suggests that investors should focus
their efforts on isolating and investing in shares that are not
currently being accurately valued by the market. The logic here is that
as the stock market begins to realize the company’s intrinsic value (through higher prices and greater demand), the investor will stand to make a lot of money.

8. Wait for the Fat Pitch

Hagstrom’s book uses the model of legendary baseball player Ted Williams
as an example of a wise investor. Williams would wait for a specific
pitch (in an area of the plate where he knew he had a high probability
of making contact with the ball) before swinging. It is said that this
discipline enabled Williams to have a higher lifetime batting average
than the average player.

Buffett, in the same way, suggests that all investors act as if they
owned a lifetime decision card with only 20 investment choice punches in
it. The logic is that this should prevent them from making mediocre
investment choices and hopefully, by extension, enhance the overall
returns of their respective portfolios.

Bottom Line

“The Warren Buffett Portfolio” is a timeless book that offers valuable
insight into the psychological mindset of the legendary investor Warren
Buffett. Of course, if learning how to invest like Warren Buffett were
as easy as reading a book, everyone would be rich! But if you take that
time and effort to implement some of Buffett’s proven strategies, you
could be on your way to better stock selection and greater returns.


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