Saturday, February 28, 2009

The Warren Buffet Way: Conclusion

The following summary was written by Frank Voisin, who regularly writes for Frankly Speaking. Recently, Frank sold four restaurants and returned to school to complete a combined LLB/MBA.

Last week, we looked at the value tenets of Warren Buffett. We conclude the book by looking at Buffett's views on portfolio management and the psychology of money as reported by Hagstrom.

Portfolio Management
Buffett says to become a “focus” investor. This means concentrating your investments in outstanding companies run by strong managers and holding on to these investments for 5 - 10 years at the bare minimum. Stop thinking in seconds, minutes, days or months, and shift to thinking about years and decades. Sell infrequently, as this reduces transaction costs and increases after-tax returns.

Recognize that a drop in the market price is not risk. Risk is the possibility of harm to the company’s fundamentals, which affect the company’s intrinsic value. Risk is NOT the price behaviour of its stock which is affected by the largely irrational mindset of the markets. Ignore pricing volatility. Invest only if you are able to watch the stock price drop 50% without breaking a sweat (assuming the fundamentals don’t change)

Focus your investment on a few companies - 10 to 20, which you can truly understand. Any more and you are inviting trouble. Somewhat counterintuitively, diversification may increase risk if it causes you to invest in areas beyond your circle of competence, leading to investments you don’t fully understand.

The Psychology of Money
True investors are calm (know that stock prices will rebound so long as the fundamentals stay the same), patient (wait for the right opportunities and ignore the popular and overpriced stocks), and rational (approach the market with neither undue pessimism nor irrational optimism).

Overcome the biases associated with investment by creating set rules and thresholds that you will adhere to. Only invest or divest of companies if certain predetermined rules are met. This will ensure that you behave rationally rather than fall into the institutional imperative of the investment community.

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