"You see, Barack, most investors are just too optimistic to be rational investors."
When Warren Buffett speaks, you'd be wise to listen. He's undoubtedly the best investor of all time. And unlike most successful investors, he's more than happy to explain how he beats the market and thinks about the future.
During his annual Berkshire Hathaway meeting, he was asked the most difficult and most important question of them all: "How do you value a business?"
In traditional Buffett style, he answered simply. You value a business, and beat the market, by being realistic.
"Intrinsic value is terribly important but very fuzzy. We try to work with businesses where we have fairly high probability of knowing what the future will hold. If you calculate intrinsic value properly, you factor in things like declining prices."
This is, in essence, the key behind value investing and Warren Buffett's success. He later added that he's "never seen an investment banker's book in which future earnings are projected to go down. But many businesses' earnings go down." Warren Buffett always seems optimistic about America's future, but his actual forecasts aren't always as rosy.
Being a skeptical investor
My colleague, David Hanson, wrote that most investors should avoid analysts' opinions. And they should. Not only are analysts hyper-focused on the next three months, not the next ten years, but they're terrible at predicting the future because they're almost always too optimistic.
The chart below shows that optimism. When analysts make forward forecasts, they seemingly just add to earnings year after year. And in most years, their estimates are slowly revised as their optimism proves to be unfounded. Only in years with robust economic growth do earnings match their estimations.
Source: Zero Hedge
Of course, we shouldn't be too hard on Wall Street analysts -- projecting the future isn't easy. But what I want to point out is that you can be an excellent investor just by being less optimistic than everyone else.
How Buffett uses skepticism to his advantage
At its core, investing is simple. It's all about buying dollars in the future at the lowest possible price today.
When Buffett buys a business -- either in whole, or in part -- he starts with basic, less-than-rosy projections about the future. Usually, the future results in better performance than expected, and thus his returns are higher than he originally planned. By having his exceptions low, Buffett is often pleasantly surprised and rewarded with billions.
But by remaining a little more critical of a business' future, Buffett ensures he's buying future dollars at a price less than most investors would pay, which is the key variable in beating the market.
