Warren Buffett is the greatest investor of all time so it is worthwhile to figure out how to invest in stocks like he does. Thankfully, Warren has spent his life giving away his wisdom on investing for free to all who would listen. Read on for Warren Buffett's top three insights on how to invest in stocks.
How to invest in stocks
Buffett built his fortune running a hedge fund for 15 years and then continued building his wealth investing the capital of Berkshire Hathaway over the years following some simple principles that everyone can use. Be forewarned, like most things in life investing is simple, but not easy.
1. "Circle of Competence"
One of Buffett's biggest insights on investing is the idea of the "Circle of Competence." The basic idea is that you need to be self-aware of your knowledge and the limits of it. As Warren explained in his 1996 "Letter to Shareholders":
What an investor needs is the ability to correctly evaluate selected businesses. Note that word "selected": You don't have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.
For most people this means they are better off investing in index funds rather than owning individual stocks as they do not have the skill and knowledge to value businesses. For those whose "circle of competence" includes the skills necessary it is important to note that too often this idea is oversimplified by people saying "invest in what you know."
2. "Price is what you pay; value is what you get."
The full quote is from Berkshire Hathaway's 2008 annual letter, "Long ago, Ben Graham taught me that 'Price is what you pay; value is what you get.' Whether we're talking about socks or stocks, I like buying quality merchandise when it is marked down."
There are two important points to consider in this. First, Warren Buffett buys businesses when they are undervalued. A great business can be a terrible investment if you bought it at too high of a price. Second, he only buys high quality businesses. As he noted in another letter, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." The reason is that wonderful companies will more often surprise to the upside whereas bad businesses have a tendency to have worsening results. You can also hold wonderful businesses for decades whereas bad businesses don't last. Buffett's best investments have been when a wonderful business is marked down in price due to some short term problems which the market was freaking out about.
A good example is provided by Warren Buffett's investment in American Express in 1963. The company's stock dropped precipitously after getting caught up in the Salad Oil Scandal. Basically, American Express had loaned a large sum of money to a fraudulent trading company on the basis of its salad oil holdings, the scandal was there were no large holdings of salad oil. The fraudulent company fooled inspectors with drums of water with salad oil on top, the oil would float on top as it is lighter than water. Warren realized that while American Express was hurting in the short term, it's reputation among consumers had not suffered, consumers were still using its cards, and its business was still solid. Warren Buffett bought a 5% stake in American Express for $13 million dollars. Berkshire has since upped its stake to 14.2% of American Express, which is now worth $13.7 billion. This brings me to Buffett's final insight on how to invest in stocks.
3. How to become rich
"I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful."
Warren Buffett gave that timeless advice in his 20s while learning how to invest in stocks from Ben Graham at Columbia. This is both profoundly simple and extremely hard at the same time. Most people get excited about investing when everyone else is; that's fine. The trick is to educate yourself and learn as much as you can about investing so that when opportunities arise you are prepared to take them. Buffett has said that students of investing really only need "two well-taught courses: How to Value a Business, and How to Think About Market Prices." Once you learn how to value businesses and how to think about the market, you truly have the two skills you need to find undervalued investments and grow rich. It really is as simple as that.
Dan Dzombak can be found on Twitter @DanDzombak, on his Facebook page DanDzombak, or on his blog where he writes about investing, happiness, life, and success. He has no position in any stocks mentioned. The Motley Fool recommends Berkshire Hathaway, Michael Kors Holdings, and Tesla Motors. The Motley Fool owns shares of Berkshire Hathaway, Michael Kors Holdings, and Tesla Motors. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.