Warren Buffett and His 20 Punches

During all of the parsing and tea leaf reading surrounding the public utterances of Warren Buffett after Berkshire Hathaway's (NYSE: BRK.A  ) (NYSE: BRK.B  ) annual meeting, I've been thinking a great deal about one of the most provocative ideas that Buffett has ever proffered: the 20-idea punch card.

I thought about it after Vice Chairman Charlie Munger mentioned that he thought that the belief that liquidity in the stock market had somehow been a great contribution to capitalism was "twaddle." This comes from someone who has made a career of investing patiently, and then when he found something of suitable interest, betting huge. Let the record show that he's done somewhat better than average in his investing career. And though both Munger and Buffett are hyperintelligent and well educated, they both agree that the secret to their success comes down to one key element: discipline. If you're not trembling with greed, you're not going to waste the opportunity.

Thus, the 20 transaction card. It's pretty simple: Each time you buy a new company, your card gets punched. After 20 punches, you're finished. No more stocks, ever.

Of course, it would be disingenuous not to recognize that Buffett himself has made many, many more transactions than 20 in his lifetime. That's not really the point. It's not a "Here's what you should do" exercise -- it's a "Think as if you had to" one. So, take a look at your portfolio. If you could only make 20 decisions in a lifetime, how many of your current holdings would make the grade? And if you own more than 20 at this moment, which companies would you get rid of?

The genius of the punch card
If you've spent any time on a stock discussion board, you've seen some variation of this: Some person wanders onto a folder, says he's a shareholder, and then asks a question that belies the fact that the guy has no idea what the company does. Think about this for a minute: If you were to spend $5,000 on a vacation, you'd most likely do a lot of research to maximize your return on investment. If you've been eyeballing the latest Sony (NYSE: SNE  ) flat-screen monster TV, you're going to take the time to know what you're getting before you shell out the big bucks.

It's true with almost any large discretionary expenditure. And yet people show extraordinary willingness to put their money at risk on companies they know nothing about. To me, this shows a basic mental block when it comes to money. Why does a $1,000 car repair bill throw people into paroxysms, where $1,000 in a brokerage account amounts to "play money"? I figure it's the same thing as the genius of poker chips -- you no longer view them as having the same underlying currency value. If I lose on this hand or this trade, eh, so what? I've got plenty of chips left.

Clearly such an attitude has helped a good many people torpedo their financial futures, either one bad trade at a time, or in times of rapid decline, all at once. But what happens when you take the discipline of thinking of trades as being extremely precious and limited in quantity? Does that change the perception of each one?

Where this concept becomes beneficial is in the way that it creates a much higher awareness of the type of trading cost that many investors fail to value: opportunity cost. Whenever you are buying a stock, you are in essence making the following claim: "At this moment, I see no better place in the world for my money than this one." Your statement is the exact opposite when you sell. "I've searched all of my worldly possessions, and there is nothing that I think that is more disposable to me than this particular asset." That's what stocks are: assets. They're claims on the future earnings of the underlying company.

If you only get to make 20 decisions ever, that would make you value each and every transaction a heck of a lot more than otherwise, don't you think? So many investors still seem to take the "Fire, ready, aim" approach to deploying their own assets. Buy something because Joe from the gym mentioned it -- heck, it's going up! -- and endeavor to learn about the company later. Maybe. Put a sell-stop in just in case it drops, because that will protect you, right?

But is there anything at all more protective than a high level of knowledge? If you have taken the time to really get to know a company, do you need to ask someone else what they think of it? Do you need the immediate confirmation of the stock market? If you've done your homework, I suggest that you don't. Further, you won't be left in a position of doing what millions of individual investors do: buying something they don't understand, watching the stock drop a little bit, and selling at the wrong time, at the wrong price, for the wrong reasons. Selling at the wrong time wouldn't be as tragic but for the fact that they likely bought at the wrong time as well. While good ole Joe may have had the best of intentions when he gave you the stock tip, he didn't know that much about the company either; he bought it after getting a hot stock tip from someone who heard on Bubblevision that an analyst had upgraded it to "strong buy" and those folks know what they're doing, because they're professionals, right?

Consider the discipline that you would show instead if there were a bean counter ready to shut off the spigot on new investments. Right away, this is bound to make you focus intently on your decisions. You would likely limit your investing to areas and industries that you have studied. While it is certainly possible for a poet to become an expert on the competitive advantages of a Cisco (Nasdaq: CSCO  ) or a General Electric (NYSE: GE  ) , she would be much less likely just to throw money that way and hope it all works out. She'd be perfectly aware of where she had competence and where she did not. And should she feel the overwhelming need to diversify, she'd more than likely get to know the industry and all of its characteristics first. And even after all of this, she'd want to be sure that her newest idea is better than all of her existing ideas. After all, what's the point of putting money into an inferior investment?

What about diversity?
A 20-punch limitation would make a wide diversification more or less impossible. In December 2000, I noted that someone would be diversified with a stock portfolio that contained three companies -- Church & Dwight (NYSE: CHD  ) , White Mountains Insurance (NYSE: WTM  ) , and Yahoo! (Nasdaq: YHOO  ) --because it is a rare economic event that would have an impact on insurance, the Internet, and baking soda.

But I contend that the person who has invested in these three companies because he knows them forward and backward has learned that these managements are focused on the things that matter to long-term shareholders and are capable of achieving these goals. He has a great advantage over the investor who owns them in ignorance. Two people can own the same three companies (and what are the odds of that with this motley bunch?), but the margin of safety for one is far higher than for the other due solely to the level of knowledge. Holding a large number of stocks prevents an investor from making a mortal mistake, but it also prevents him from garnering wealth-altering returns off your best ideas.

And that's the point of the exercise. There's no limitation for how many times you can trade, but think about the care that you would put into each decision if there were. A wasted decision in this case would be nearly as hobbling as a loss in capital, which would mean that each decision would be taken with the greatest of care, after you've taken the time to tear the company limb from limb to understand what you're getting into. It's the polar opposite of what the majority of investors do: Less than 30% of all investors ever read an annual report. Even taking this step before you leap has to create some informational advantage over people whose knowledge of companies is limited to whether they went up or not.

Fool on!
Bill Mann, TMFOtter on the Fool Discussion Boards

Could Mathew Emmert's latest idea be one of the 20? There's only one way to find out -- take a freetrialof Motley Fool Income Investor today!

Despite their common first name and an uncanny resemblance, Bill Mann denies reports that he is really William Hung. Bill owns shares of Berkshire Hathaway and White Mountains Insurance.The Motley Fool is investors writing for investors.


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