Warren Buffett's Biggest Secret for Success

Most people know Warren Buffett as one of the richest men in the world, who took a relatively small sum of money and turned it into one of the largest companies in the United States, Berkshire Hathaway  (NYSE: BRK-B  ) (NYSE: BRK-A  ) .

When most people try to copy Buffett's style, they tend to focus on how he finds the hidden upside-potential in stocks, but that's not the most important thing. The best thing you can do for your portfolio is to think defensively, that is, to pick and choose companies that will do well when the rest of the market is doing poorly.

Why is it so important?
Stocks tend to go up over time. In fact, they have outperformed essentially every other asset class over any long period of time, so why do we care so much about the bad years?

Simply put, negative years have more of an impact on long-term performance. If your portfolio loses 20% in a year, you would need your stocks to gain 25% the next year just to break even.

To illustrate this point, consider two scenarios.

First, let's consider an aggressive investor whose portfolio returns an average of 20% during the years the market rises, but loses 15% during "down" years. Then, consider a defensive investor who makes 15% during positive years, but only loses 5% during negative ones. For simplicity's sake, let's assume we have two positive years for every one bad year.

As you can see, the defensive portfolio beats our aggressive example by about 30% over a 30-year timeframe.

The proof is in Berkshire's performance
You might be surprised to hear Berkshire has actually underperformed the S&P in four out of the last five years. In fact, the only year Berkshire beat the S&P, 2011, was the only year the market didn't post double-digit gains.

Generally, when the market shoots to the upside, the riskier and more volatile stocks tend to benefit the most. Well, that is exactly the type of investment Berkshire doesn't make. However, consider a year like 2008, when the market was in panic-mode. The S&P lost 37% of its value during that year, but Berkshire Hathaway's book value per share only dropped 9.6%.

In other words, the S&P needed to gain 59% to make up for its 2008 losses, which took the next four years to do. Berkshire, on the other hand, only needed an 11% rise to get back to even, which it achieved and more the very next year.

To further illustrate just how rock-solid Berkshire's portfolio is, here is perhaps the most impressive fact about the company's performance.

The S&P has had 11 down years out of the past 50. Berkshire's portfolio beat the S&P in each and every single one of those years. There has not been one single down year where the company's book value per share fell more than the broader market. That is the kind of performance that builds wealth.

The lesson to learn
The most successful investors know creating wealth isn't about finding the next big thing or taking lots of risks to possibly produce gains. In baseball terms, a hitter with 300 singles is much more valuable to his team than one with just a few home runs, and the same applies to investing.

As Buffett said to shareholders at this year's annual meeting, "In up years, we'll underperform, we'll outperform in down years, and over any cycle, we'll outperform."

Warren Buffett is buying this "defensive" stock
Imagine a company that rents a very specific and valuable piece of machinery for $41,000 per hour (That's almost as much as the average American makes in a year!). And Warren Buffett is so confident in this company's can't-live-without-it business model, he just loaded up on 8.8 million shares. An exclusive, brand-new Motley Fool report details this company that already has over 50% market share. Just click HERE to discover more about this industry-leading stock... and join Buffett in his quest for a veritable landslide of profits!

Read/Post Comments (5) | Recommend This Article (2)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 05, 2014, at 10:38 AM, FoolforBerky wrote:

    Nicely done.

  • Report this Comment On July 06, 2014, at 5:10 PM, AnsgarJohn wrote:

    The key is that Buffett doesn't compare Berkshire's Mr. Market price to the S&P 500 but Berkshire Hathaway's book value which in the short term is less variable than price.

    Read Superinvestors to get Buffett's own explanation.

  • Report this Comment On July 06, 2014, at 8:14 PM, ellenwood wrote:

    It's a shame. Bank of America has operated poorly. They are more inclined to steal from the civilians and give freebies to law enforcement

    People need to understand everyone working for the court is not an officer. Look at the pension it's a world of difference

  • Report this Comment On July 06, 2014, at 8:19 PM, ellenwood wrote:

    Investors buy house that are not suitable for rentals. Lack of education.

  • Report this Comment On July 06, 2014, at 8:21 PM, ellenwood wrote:

    The an employee of the Superior Court of County of losangeles used are home loan info as if we were renters for Sharon Fox to qualify as an investor to purchase her home in Palmdale california. And bank of america knew

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Matthew Frankel

Matt brought his love of teaching and investing to the Fool in order to help people invest better, after several years as a math teacher. Matt specializes in writing about the best opportunities in bank stocks, real estate, and personal finance, but loves any investment at the right price. Follow me on Twitter to keep up with all of the best financial coverage!

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8/28/2015 4:00 PM
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Berkshire Hathaway CAPS Rating: *****