How To Think, Act and Invest Like Warren Buffett

This post contains my personal notes from the book, ” Think, Act and Invest Like Warren Buffett” by Larry Swedroe

START TAKING HIS ADVICE

Warren Buffett is considered by many as the world’s greatest investor. Let us listen to what he has to say about investing.

1. Whether you should invest in actively managed or passively managed funds( like index funds/ETFs)

By periodically investing in an index fund, the know-nothing investor can actually outperform most investment professionals. Paradoxically, when “dumb” money acknowledges its limitations, it ceases to be dumb.

Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals. Seriously, costs matter.

So many investors, brokers and money managers hate to admit it, but the best place for the average retail investor to put his or her money is in index funds.

Over the 35 years, American business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns: All they had to do was piggyback Corporate America in a diversified, low-expense way. An index fund that they never touched would have done the job. Instead many investors have had experiences ranging from mediocre to disastrous.

2. Whether you should listen to market forecasts

We have long felt that the only value of stock forecasters is to make fortune-tellers look good. Even now, Charlie (Munger) and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children.

A prediction about the direction of the stock market tells you nothing about where stocks are headed, but a whole lot about the person doing the predicting.

3. Whether you should try to time the market

Our favourite holding period is forever.

Our stay-put behavior reflects our view that the stock market serves as a relocation center at which money is moved from the active to the patient.

Success in investing doesn’t correlate with IQ once you’re above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.

Inactivity strikes us as intelligent behaviour.

Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.

A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful.

The most common cause of low prices is pessimism — sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer. None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What’s required is thinking rather than polling.

These things can be easily done by having an investment plan based on index funds and regular rebalancing.

START THINKING LIKE HE DOES

1. How to think about bad news

The market price already reflects all publicly available information. This means that bad news does not mean that stock prices have to go lower or good news means that stock prices have to go higher. In order to be a successful investor, what you need to understand is whether the news is better or worse than already expected. In other words, what matters is not whether news is good or bad but whether or not it is a surprise. If the news is better than expected, then stock prices will go up. If the news is worse than expected, then stock prices will go down. If you want to invest more like Buffett, you must understand that surprises are a major determinant of stock performance. Because they are unpredictable and instantly incorporated into stock prices, you are best served by ignoring the news, because acting on it is likely to prove counterproductive.

2. Avoid stage-one thinking

Stage one thinking is thinking about the crisis and the risks but not seeing beyond that. Stage two thinking is thinking like the following:

  • Do I know something the market doesn’t?
  • Is the news already incorporated into the prices?
  • Do I want to sell when the valuations are low and the expected returns are high?
  • Will governments and central banks do nothing or address the problem?
  • Have I reacted in the past to similar events and how did that turn out?
  • If I sell now, how will I know when it is safe to buy again?

The other thing to remember about markets is it always looks dangerous. It can always fall down. If everything seems safe then prices are probably high. Buying when valuations are high and selling when they are low explains why so many investors have taken all the risks of stocks but have ended with bond-like returns.

That is why Buffett says,

The most important quality for an investor is temperament, not intellect.

Investing is simple, but not easy.

You have learn not to allow greed and fear to control you. The best way to do that is to have a plan, stick to it and ignore the forecasters and the experts.

3. Have a plan and stick to it

Buffett says,

In the stock market you do not base your decisions on what the market is doing, but on what you think is rational.

Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.

So, to be successful in investing you need to have a personal plan that determines your asset allocation based on your ability, willingness and need to take risk. Once you make the plan you need to stick with it.

So,

  • Do not act on market forecasts.
  • Do not try to time the market.
  • Do not sell after markets after experienced big losses and buy after they have recovered.
  • Adhere to your invest plan and asset allocation, only rebalancing and tax managing as required.

SHOULD YOU BE AN ACTIVE OR PASSIVE INVESTOR?

Active investing is the art of stock selection and market timing. Passive investing accepts that the market price is the best estimate of the value of a stock and one cannot beat the market consistently, after all expenses. But everyone dangles the hope of beating the market by active investing but actually make money out of you. But the evidence shows that almost everyone has failed to beat the market.This is true for individual investors, actively managed mutual funds and pension plans.

The arithmetic of investing is simple:

  • Total market return= Active investor return + Passive investor return.
  • Let us assume active investors=70% of market and passive investors=30% market and total market return=10%
  • The passive market return is 10%
  • 10%= 70% x b+ 30% x 10%
  • 10%= 70%b + 3%
  • 70%b=7%
  • b=10%
  • Active investor return=10%

So, as a group active investor returns=passive investor returns= market return.

But active investor have higher expenses, trading costs, bid-offer spreads, brokerage commissions, market impact and cost of cash leading to lesser returns than passive funds. So the best way is to invest in passive funds or ETFs like Charles Schwab, Fidelity, Vanguard, Bridgeway, DFA, Invesco or Wisdom Tree. This is the right strategy to adopt.

THE NEED TO PLAN: IT IS NOT ONLY ABOUT INVESTMENTS

  • You need to have a plan. The plan is your investment policy statement(IPS).
  • The IPS should lay out the plan’s objectives and the road map to achieving them. The plan helps you make rational decisions. You should look at how each investment affects the risk and expected return of your portfolio and hence the odds of achieving your objectives.
  • The IPS should be altered if any assumptions change. It should be reviewed when a major life event occurs and also depending on market movements. You should review the IPS and its assumptions annually.
  • You should consider your personal and financial status, the stability of your job, whether the risk of your job is highly correlated with your stock holdings, your investment horizon( may extend beyond planned retirement date or even beyond your death), your tolerance for risk and the need for emergency reserves and the need to take risk( why take more risk if you are already rich).
  • Your investment plan should be incorporated into a financial plan that addresses estate and tax planning, the need for life, health, disability, long-term care, personal liability and longevity insurance. It should address when you are going to take your social security and your charity goals and how you are going to transfer wealth to your family.
  • It should have contingency plans, the specific wealth accumulation and investment goals and  asset allocation and rebalancing targets.

HOW MUCH RISK YOU SHOULD TAKE-THE ASSET ALLOCATION DECISION

1. The ability to take risk

  • You can take more risk if your investment horizon is long. If your investment horizon is long, it is more likely that stocks will provide higher returns than bonds
  • The second thing to consider is your human labour capital. When we are young this capital is at its highest and decreases as we grow older. We also have to consider whether our labour capital is stable or volatile. We should also consider the significance of this labour capital as a percentage of total assets. To avoid having too many eggs in one basket, do not invest in assets that have a high correlation with your human capital. Human capital can be lost because of two risks: disability and death. You need to cover for this using insurance.
  • The third thing to consider is the need for liquidity. This is determined by the need for near-term cash requirements as well as the potential for unanticipated calls on capital. You need have a reserve to cover a minimum of 6 months of ordinary expenses.

Investment horizon and maximum stock allocation

2. The willingness to take risk

The willingness to take risk is determined by the maximum tolerable loss that your stomach can handle when markets crash. It is not worth to take more risk than this because life is too short not to enjoy it. The maximum tolerable loss is independent of the time frame.

Maximum tolerable loss and maximum stock exposure

3. The need to take risk

The need to take risk is determined by the rate of return required to achieve your financial objectives. If your goals are high and the return needed is high, you need to take more risk. It is important here to differentiate between needs and desires and there are no right or wrong answers here. But if your needs are less, then you need to take less risk.

4. The make up of your portfolio

The risk and expected(not guaranteed) return of your portfolio is determined mainly by asset allocation. Riskier assets have higher expected(not guaranteed) returns). If the returns are guaranteed there will be no risk.

Stocks

The decisions to make are:

  1. Percentage of stocks versus bonds.
  2. Percentage of US, International Developed and Emerging market stocks
  3. Percentage of small=cap/large-cap and value/growth

Small cap and value stocks have higher expected returns and also are very good diversifiers of your portfolio. Diversification is important because nobody can determine in advance which asset class will do well. It is the only free lunch.

Bonds

Bonds have two risk factors: term( years to maturity) and default(credit). The longer the maturity and lower the credit rating, the higher the risk. The main aim of bond investing is to dampen the risk in your portfolio. So you should invest in FDIC insured CDs, US government bonds and highly rated(AAA/AA) municipal bonds. If you want to own corporate bonds you should invest in investment grade( rating that indicates a low rate of default) corporate bonds with remaining maturities of three years or less.

Alternative investments

The only two alternative investments worth considering are real estate and commodities which can be bought by REIT index funds and commodity index funds/ETFS.

The asset location decision

  • Invest first in tax-advantaged accounts
  • REITs and commodities should held in tax-advantaged accounts. If you cannot then you should consider passing their diversification benefits.
  • If you are a taxable investor, you should invest in stocks in taxable accounts and bonds in tax-advantaged accounts.

Should you invest in mutual funds or securities?

You have to understand that there are two types of risk: good risk and bad risk. Good risk is the type of risk you are compensated for taking, like risk that comes from investing in the stock market. Bad risk is uncompensated or unsystematic risk. Bad risk is investing in one asset class, few companies, speculating, investing in sector funds and investing in single country funds( except US). So when you invest in stocks or bonds you should invest in mutual funds only. With US government bonds you can invest in them individually or in funds. Mutual funds and ETFs are also convenient to invest. So it is better investing in mutual funds.

HOW TO BUILD A WELL-DESIGNED PORTFOLIO

The following table shows how by increasing the number of asset classes you can increase return and decrease risk. One has to look at what is available to them and the costs of maintaining a portfolio while considering the more complex portfolios.

Designing well diversified portfolios

You can also lower risk with an acceptable lower return by increasing the bond allocation.  An example is shown below:

60%bonds 40%  diversified equity portfolio returns

The returns that are got by these portfolios are not average returns, they are market returns achieved in a low-coat and tax efficient manner and by such an approach you will most likely beat the majority of individual and institutional investors. The main thing is to stick to the investment plan until you achieve your financial goals. Your only activities should be rebalancing, managing for taxes and adjusting the plan if the underlying assumptions change.

THE CARE AND MAINTAINENCE OF YOUR PORTFOLIO

Rebalancing

Rebalancing is regularly selling and buying assets in your portfolio to your target asset allocation. It helps you buy low and sell high and increases return. However rebalancing may cause transaction fees and may also have tax implications. A reasonable rule of thumb is to use the 5/25 percent rule. This means you will rebalance only if the change in the asset class’s allocation is greater than an absolute 5% or 25% of the original target allocation, whichever is less. Apply this test at least quarterly and apply it at three levels:

  • The broad level of stocks and bonds
  • The level of domestic and international asset classes
  • The more narrowly defined individual asset class level( such as emerging markets, real estate, small-cap, value, and so on)

You should have a table which states the target allocation, minimum and maximum allocation for each asset class beyond which you will rebalance. An example is shown below:

Rebalanicng targets -1Rebalancing targets-2

You can rebalance in two ways:

  • Sell what has done relatively well and buy what has done relatively poorly
  • Use new cash to raise the allocations of the asset classes that are below targeted levels.

Other things you may consider doing on a case by case basis are:

  • Have distributions paid in cash rather than automatically reinvested.
  • See if you will get new funds in the near future and not rebalance till the new cash is available if capital gains taxes are going to be generated
  • Delay rebalancing if short-term capital gains tax are going to be generated
  • Consider rebalancing only to the minimum or maximum target allocation rather than the target allocation if significant taxes are generated.

Tax management

  • Choose the most tax-efficient vehicles
  • Sell fund with losses throughout the year if the value of the tax deduction significantly exceeds transaction costs, and immediately reinvest the proceeds in a manner that avoids the wash-sale rule. Perform tax-loss harvesting throughout the year rather than at the end of the year.
  • Sell the highest-cost basis lots first to minimize gains and maximize losses.
  • Try to avoid short-term capital gains as much as possible.
  • Do not buy within 30-60 days of the ex-dividend date.
  • Trade around distributions. Buy after distributions and sell before distributions.

SHOULD YOU HIRE A FINANCIAL ADVISOR

To do it yourself, you should be able to do the following:

  • Develop an investment plan and have an estate, tax and risk management( insurance of all types) plan and maintain it.
  • Have mathematical skills to determine an appropriate asset allocation
  • Have the ability to determine an asset allocation to meet your financial goals
  • Have knowledge of financial history
  • Have the temperament and emotional discipline to adhere to an investment plan

If you cannot you should hire a financial advisory firm that has the following:

  • A fiduciary standard of care: They should act in your best interests always. They should be a fee-only advisor, have no conflicts of interest, and invest with the same principles and in the same investment vehicles.
  • Advice based on science( evidence from peer-reviewed journals), not opinions
  • Investment planning that has been integrated into an overall financial plan, including insurance, estate planning, retirement planning, education, rebalancing, college funding, selecting investments for employer plans, gifting, home purchase and mortgage financing decisions, tracking your plan, etc.

WINNING THE GAME OF LIFE

Passive investing, in the manner we have talked so far makes investing simpler and less time consuming so that you can focus on the other important things in your life: the big rocks. Investing is never meant to be exciting. It is about achieving your financial goals with the least amount of risk. To give yourself the best chance of achieving that follow the 30 rules of prudent investing.

While it is a tragedy that the vast majority of investors unnecessarily miss out on market returns that are available to anyone adopting a passive investment strategy, the truly great tragedy is that they miss out on the important things in life in pursuit of what I call the “Holy Grail of Outperformance.”

I hope this post will lead you to the winner’s game in investing, and far more important, life.

Advertisements

One thought on “How To Think, Act and Invest Like Warren Buffett

Comments are closed.