How Warren Buffett Invests: Part 3

By Dale Gillham | Published 04 June 2018

So let's continue with Part 3 of the series on how Warren Buffett invests. 

Part 1 of how Warren Buffett invests

Part 2 of how Warren Buffett invests

5. Invest in companies and industries that you understand

Only make investments that you understand. Warren Buffett says that many people think quite a bit before making any investment and sometimes they think too much.

This is where paralysis of analysis can become an issue that impedes your success. Buffett cautions that you should never invest in businesses that you do not fully understand.

He says that before he invests, he has to first understand how the company makes money, and the main drivers that impact its industry. If he's not able to understand this in 10 minutes, he moves on to evaluate another company on this basis. Now you can’t really fault that thinking can you!

Most people cannot predict the next fashion trend among teenagers or whether or not a medicine will be successful in the market.

Even if you had more data than anyone else, it is still impossible to predict the future with 100 per cent accuracy.

In situations that rely on an accurate forecast of the future, Buffett advises not to invest.

If it's too complex for you, just look for another businesses to invest in.

When I am teaching traders, one of my mantras is to keep things simple and I think this is what Buffet is saying.

All too often, I find investors and traders in markets or trades that they do not understand and this causes emotional decision making and poor returns.

I also have to agree with Buffet that if no companies on your list fit your investment criteria, stay in cash. Cash is a position.

6. Buying a stock of a company is buying a part of a business 

Imagine you are buying an ownership stake in the convenience store around the corner from your house. Automatically you will think about the competition, suppliers, prices, etc.

You will have to think about both the specific location, as well as its competitive position in the market.

Similarly, when buying stocks, you need to think about all these things - just as the people running the business do. When you buy a stock, you are not just buying a piece of paper or a ticker symbol.

Buying the stock is buying an ownership stake in a business.

I think many people forget about this and often do not think of stocks they own as assets in the same way they think of real estate.

They often treat the market and the buying and selling of stocks more like a place to gamble.

We saw this in the tech wreck and other booms, where the masses invested in assets that had little or no intrinsic value, or profits.   

7. Manage your risk

This is my favourite area to talk about with traders because I find the majority, while they intellectually give the impression they know, really do not understand how to manage risk.

Buffets - Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.

Buffets other famous quote: Risk comes from not knowing what you're doing.

In my experience, 90 per cent of traders and a large percentage of investors do not heed this advice. Buffet suggests that when a company no longer matches your reasons for buying, sell the stock.

If you determined it needs to be above its two-year average stock price, and it falls beneath it, then you sell. This is what most Buffett followers miss.

He has rules and he diligently follows them. When a company no longer fits his criteria, he sells.

Resist the urge to make excuses to stay in the investment. Sell it. Period. I totally agree with him.

I teach traders to position trade and this means buying low, as Buffet teaches and then to hold the position until the risk of holding it becomes too high.

Again, while we may go about the exercise in a different way, both Buffet and I agree on the buy low and sell high principle.

8. Learn from your mistakes and move on

You might be astonished to know that even Warren Buffett makes mistakes - big ones too. But he makes sure that he learns from his mistakes.

Buffett advises keeping a record of the mistakes you have made so that you know what went wrong and 'to make sure you do not repeat them again.

Documenting your mistakes is a way of taking responsibility for them because all too often we sweep mistakes under the carpet in an attempt to hide, as if they never occurred and this then breeds a false reality.

Being disciplined and accountable are both traits of excellent traders.

Buffett further states that you should share these lessons with your children and grandchildren, so that they know what mistakes not to commit. I really thank him for not only sharing his lesson with his family but with the world.

Although, what I think is sad is that while his words of wisdom are excellent and highly valuable, the majority either do not listen or do the opposite and this is a tragedy.

I hope you enjoyed this series on Buffet’s words of wisdom.

Whether you desire is to be a good investor or trader, you would be wise to follow his wisdom. 

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