Don't think you have any business being in the stock market? Warren Buffett wants you to think again.
Image Source: The Motley Fool.
The surprising insight
In an interview with CNBC's Becky Quick earlier this year, Buffett was asked why he began the "Some Thoughts About Investing" section of his 2013 letter to Berkshire Hathaway (BRK.A -0.60%) (BRK.B -0.50%) shareholders by highlighting a farm 50 miles north of Omaha, Nebraska, he bought in 1986 and a retail property near New York University in New York City that he purchased in 1993.
Quick said many had speculated Buffett was indirectly implying he felt real estate was a better investment than stocks. She asked, "do you think that real estate and other areas are better places for money than stocks right now?"
Buffett's response was direct and surprising:
No, they're speculating wrong. I used those illustrations because I don't know that much about real estate or farms. And yet it was still possible to successfully invest them. And -- I feel the same way about people on stocks ... you can have a great, long -- lifelong experience in stocks and really not be a specialist in accounting.
With the financial crisis still on the minds of many Americans, accounting scandals aplenty, and respected author Michael Lewis boldly asserting on 60 Minutes that "the United States stock market, the most iconic market in global capitalism, is rigged," it is easy to think an average American can't many money investing.
But Buffett -- and countless others -- want us to think differently about stocks.
Buffett's strategy
So how should we begin? In the letter to investors, Buffett outlined his "fundamentals of investing." He began by noting:
You don't need to be an expert in order to achieve satisfactory investment returns. But if you aren't, you must recognize your limitations and follow a course certain to work reasonably well. Keep things simple and don't swing for the fences.
Although we don't need to be experts in the nuanced aspects of a business and the accounting that accompanies it, Buffett has time and again noted that when considering an investment, we must stick to our circle of competence and avoid the industries and areas we know nothing about.
Buffett may not have known everything about the farming and real estate industries, but he learned enough about the underlying business dynamics of the farm in Nebraska and the property in New York to feel comfortable investing in them. In the same way, we should only invest in companies whose businesses we firmly understand.
Or, as he once put it, "if you're good at one thing you're not necessarily good at another, you ought to use your talents where they're most useful and get others to use theirs."
Official White House Photo by Pete Souza.
In the letter he also suggested individuals must attempt to understand the future productivity of whatever they're buying, whether it be a stock, farm, or piece of property. If all signs indicate the asset will be productive and continue to produce profits in years and decades to come, it could be a worthwhile investment (though price also plays into the matter).
On the subject of price, Buffett suggested that speculating on the future price of an investment, rather than its future productivity or value, is incredibly dangerous.
We mustn't be swayed by day-to-day fluctuations in price and broader market or economic conditions. Instead, we should seek understanding of the true long-term value of the investment itself. We must always understand investments are made in businesses, not numbers on screens or pieces of paper.
In summation, Buffett noted that when he and longtime business partner Charlie Munger invest in stocks -- which they "think of as small portions of businesses" -- their "analysis is very similar to that which we use in buying entire businesses":
We first have to decide whether we can sensibly estimate an earnings range for five years out, or more. If the answer is yes, we will buy the stock (or business) if it sells at a reasonable price in relation to the bottom boundary of our estimate. If, however, we lack the ability to estimate future earnings -- which is usually the case -- we simply move on to other prospects.
The key distinction
Of course, it takes time and effort to meet all these steps. This is why Buffett once said, "if you like spending six to eight hours per week working on investments, do it. If you don't, then dollar-cost average into index funds."
That comment suggests diligent saving and investing in low-cost index funds can also be a great way to prepare for retirement. This is an important distinction because while Buffett thinks stocks can be for everyone, he didn't say they should be. In short, he understands many may not have the time, energy, or desire to make their own investment decisions-- in which case index funds are the next best alternative.
Buffett has said "the stock market is designed to transfer money from the active to the patient." While we might not have the same success as Buffett, we can certainly succeed by focusing on investing in quality businesses at reasonable prices with a long-term focus.
