"To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What's needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework." -- Warren Buffett
Think about that quote for a minute. Warren Buffett, the greatest investor of all time, is pointedly saying that anybody can be a successful investor assuming they have two things: First, a "sound intellectual framework for making decisions," and second, the "ability to keep emotions from corroding that framework."
Every professional discipline has a set way to approach a problem. Law school teaches people to think like lawyers. Medical school instructs students on how to make diagnoses. And engineers learn how to apply scientific and mathematical principles to build physical structures.
What Buffett is saying, in other words, is that investing is like any other profession. To excel at it, you have to understand its underlying structure.
A sound intellectual framework
Reduced to its simplest form, there are three indispensable layers to a sound investing framework.
The first is critical, if not self-evident. That is, you must determine whether it's even possible for you to beat the market -- by which, I mean the S&P 500 (SNPINDEX:^GSPC).
I've discussed this subject on numerous occasions recently because, at first glance, it seems almost too obvious to even warrant mention. "Of course it's possible to beat the market," most reasonable people would conclude, "why else would there be so many people trying to do so if it weren't?"
While this is a good point, it nevertheless misses the mark. The stark reality is that we simply don't know the extent to which individual investors are in fact successful at outperforming the market. While the data exists, principally in the hands of retail brokers, they have yet to share it with anybody in the wider world -- which, it probably goes without saying, isn't encouraging.
Say, for example, Charles Schwab (NYSE:SCHW) released data showing that 75% of its brokerage customers beat the market. And on top of this, let's say the success was a result of Schwab's proprietary trading platform. What do you think would happen to its customer base? It would explode, that's what.
With this in mind, it's safe to conclude that the mere absence of data is an ominous sign.
This conclusion is bolstered by a widely held belief among economists that it's, by definition, nearly impossible to beat the market. Known as the "efficient market theorem," economists have long held that stock prices reflect all presently known information about a particular company, and therefore move in a random and unpredictable walk. Forecasting which stocks will do better than the broader market, in other words, is entirely guesswork.
Now that we've gotten the bad news out of the way, it's important to note that there are exceptions to this rule. Buffett is foremost among them. His investment acumen has allowed Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) to become one of the most successful investment vehicles of all time, handily outperforming the broader market by leaps and bounds.
While one could go on and on with a list of other notable investors, the point is, these people are professionals. They bring the same type of disciplined approach to their trade that lawyers, doctors, and engineers do. Absent this and a long string of luck, in other words, the average investor is up a creek without a paddle.
Identifying great stocks
This brings us to the second layer of a sound investment framework, which addresses the question: How does a person identify stocks that will outperform the market?
Speaking generally, there are four approaches to stock picking. The first is known as technical analysis. This consists of looking at past stock prices and using that as a guide to the future. Not to dismiss it unfairly, but this approach has been resoundingly discredited by academics and technicians in the industry.
The second approach is known as value investing. This is arguably the most popular conventional investing technique, and it's used by the likes of Buffett and others. In its simplest form, value investing consists of buying stocks when the intrinsic value of the business is higher than the value the stock market is placing on it.
The third approach is known as growth investing. Again, as its name suggests, this approach consists of picking stocks that stand a reasonable chance of outgrowing competitors and the broader market going forward. Thus, unlike value investing, which compares present valuations, the onus of a growth analysis is on forecasting the future.
And the fourth approach is a combination of any two or more of these. The most natural combination is between the latter two. And, in fact, one could say that it was this type of franchise-type focus that led Buffett to invest in companies like Coca-Cola (NYSE:KO) and American Express (NYSE:AXP).
Buffett believed both companies had fantastic franchises that would allow them to outpace the market over the long term. And this is precisely what they've done. Since 1990, they've each returned more than 1,100% compared to the S&P's still-respectable 655%.
Taking emotions out of the equation
The final layer of a sound investing framework is perhaps the most important: controlling one's emotions. As Benjamin Graham, the father of value investing, wrote in the early 1970s, "the investor's chief problem -- and even his worst enemy -- is likely to be himself."
The point is that investors have developed an unfortunate penchant for buying high and selling low. And they've done so because they're unable to control their elation when the market is peaking and their despair when it's in a trough.
Over the past few decades, psychologists have shined an enormous among of light on this subject. Among other things, they've found that investors are overconfident, irrationally risk averse, and prone to confirmation bias, all of which lead to poor investment decisions and underperforming portfolios.
The trick, in turn, is to both identify these systematic shortcomings and combat them via awareness and processes.
The Foolish bottom line
The bottom line here is that it is possible to beat the market -- or, at least, there's reason to believe it is. But in order to do so, an investor must fully and completely come to terms with each of the three layers of a sound investment framework.