Warren Buffett is arguably the most respected investor of all time, and for good reason. Over his 54-year tenure as CEO of Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B), Buffett has delivered annualized returns of 20.5% for investors as of mid-2019, more than twice the pace of the S&P 500 over the same period.

And he's done it without applying any extraordinarily complex methods. In fact, Warren Buffett's investment style is surprisingly simple, and while it's not likely that you're going to replicate Buffett's long-term performance in your own portfolio, you can certainly learn how he invests and apply the same principles to your investment strategy.

With that in mind, here's a rundown of the core principles behind how Buffett invests: mentality, stock selection, valuation methods, and more.

Warren Buffett smiling and talking to reporters.

If you delivered a 2,472,627% return for investors, you'd smile, too. Image source: The Motley Fool.

Warren Buffett invests for the long term 

Perhaps my favorite Buffett quote of all time is, "You can't produce a baby in one month by getting nine women pregnant." In other words, some things just take time.

The first thing you need to do if you want to invest like Warren Buffett is to stop chasing short-term gains. Buffett doesn't judge his investment performance by looking at how well his stocks did over the past week, month, or even year -- instead, he focuses on multiyear returns.

In fact, Buffett doesn't even buy stocks because he thinks their share prices are going to go up. He focuses on buying good businesses that are well run. This has certainly worked out in his favor, as Berkshire Hathaway's investment returns speak for themselves. As Buffett says, "If you aren't willing to own a stock for 10 years, don't even think about owning it for 10 minutes."

While there are certainly exceptions, Buffett approaches all investments as if he is going to hold them forever. If you want to invest like him, it would be a good idea to apply a similar test before considering any stock.

Warren Buffett isn't afraid to sell stocks

Buffett once said that "All there is to investing is picking good stocks at good times and staying with them as long as they remain good companies."

Pay particular attention to the latter part of this quote -- "as long as they remain good companies." While Buffett is certainly a buy-and-hold investor, he sells stocks regularly and for a variety of reasons. If Buffett's original reasons for buying a stock no longer apply, he won't hesitate to move on.

As an example, it might surprise you to learn that Buffett built a massive stake in Freddie Mac (OTC:FMCC) in the 1990s. By 1998, Berkshire owned nearly 9% of Freddie Mac, a stake worth $3.9 billion at its peak and a massive 1,200% return for Berkshire. However, in 2000, Buffett abruptly sold nearly all of the position.

Why would he get rid of such a successful investment? Buffett noticed that management became too focused on delivering quarterly results and started to take on more and more risk to achieve its goals. As we all saw during the financial crisis, these risks ended up being more than just a small warning sign.

The lesson? Don't be afraid to walk away from an investment if you don't like what's going on -- regardless of whether it's up or down. Buffett said it best when he advised that "the most important thing to do if you find yourself in a hole is to stop digging." While overtrading is a bad idea, that doesn't necessarily mean that you need to hang on to every stock indefinitely.

Warren Buffett invests in what he understands

If you look at Berkshire Hathaway's current stock portfolio -- especially Berkshire's largest holdings -- you might notice that there isn't a ton of variety. Specifically, among Berkshire's top 10 you'll find no fewer than seven banks, as well as two large investments in food companies. Apple (NASDAQ:AAPL) is the only stock not in these two categories.

Many observers might say that Berkshire's portfolio lacks diversification, and it's true. However, Buffett believes that's not necessarily a bad thing. In fact, you could even say that lack of diversification is responsible for some of Buffett's best investment returns.

Simply put, Buffett feels that it's better to have an undiversified portfolio made up of businesses he understands well than to have a diversified group of stocks he isn't well-equipped to evaluate. Buffett doesn't understand technology stocks too well, so you won't find many in his portfolio. (Note: Buffett considers Berkshire's top holding, Apple, to be more of a consumer goods company at this stage of its maturity.)

Buffett refers to this concept as staying in your "circle of competence." As he says, "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." In other words, if you know banks really well, as Buffett does, there's absolutely nothing wrong with owning a lot of bank stocks. 

Warren Buffett knows value investing basics

As Buffett likes to say, "Price is what you pay. Value is what you get." The basic concept of value investing is simple. By investing in stocks that are trading for less than they are truly worth, you have an inherent advantage as a long-term investor.

Sale sign in store window.

Buffett views value stocks like discounted merchandise. Image source: Getty Images.

However, finding stocks that are trading at a discount is easier said than done.

A full-scale discussion of value investing is beyond the scope of this article, but if you want to learn how to value invest like Buffett, the best place to turn are the teachings of Benjamin Graham (Buffett's mentor). Buffett himself has referred to Graham's book, The Intelligent Investor, as the best book on value investing ever written. After you've read that, Graham's other value investing book, Security Analysis, is a somewhat difficult read but has a fantastic discussion about calculating the intrinsic value of a company.

One big goal of Buffett's value investing methods is to try to find stocks with a margin of safety. For example, if you pay $70 for a stock with an intrinsic value of $100, the business fundamentals can erode to the point where the stock loses $30 of value per share and you'll still be in good shape.

However, Buffett cautions that the primary goal is still to invest in good businesses: "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

2 stock strengths Warren Buffett looks for

It's difficult to overstate how much value Buffett gives to outstanding management. In his mind, a great, shareholder-friendly management team can make an otherwise so-so stock attractive. Conversely, an otherwise excellent business with poor management can be a losing investment.

Look for companies with a strong track record of raising dividends and whose management team has their interests aligned with those of shareholders. For example, I like to see incentive-based compensation tied to long-term performance goals, as opposed to a single quarter's earnings.

Another concept that's important in Buffett's investing style is identifying a durable competitive advantage. For example, Apple's loyal customer base gives the company a big advantage going forward and is a big reason the stock is Berkshire's largest holding. Coca-Cola (NYSE:KO) has a massive distribution network and one of the best-known brand names in the world, the combination of which gives it efficiency advantages and pricing power over peers.

Warren Buffett hates investment fees

You won't ever catch Buffett investing Berkshire's (or his own) capital in a hedge fund. In fact, Buffett bet a half-million dollars that a simple S&P 500 index fund would outperform any basket of five hedge funds over a 10-year period -- and he won this bet handily.

Man with money flying out of his wallet.

If you pay excessive fees, it could rob you of thousands of dollars in gains over the years. Image source: Getty Images.

The reason isn't that hedge funds necessarily make bad investment decisions. Instead, it's because hedge funds have exorbitant fee structures that make a dramatic difference in investment performance and put hedge fund investors at an inherent disadvantage. As Buffett puts it, "When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients."

It's also important to mention that while Buffett was referring to hedge funds when he said this, the same concept applies to mutual funds and other investment vehicles that charge fees. This is why Buffett says that the average investor would be better off with low-cost index funds as opposed to actively managed mutual funds. You might be surprised at the impact a seemingly small difference in investment fees can have over a period of decades.

For example, let's say that you have two investment choices: a S&P 500 index fund with a 0.05% expense ratio and an actively managed large-cap stock fund that charges 0.50%, which is well below average for an active fund. We'll say that you put $10,000 in each. Assuming that both funds' underlying investments grow at an annualized pace of 10% per year, after 30 years, the lower-cost fund would be worth about $17,600 more than the actively managed fund.

If you were paying 1% on the actively managed fund, you would underperform the index fund by a staggering $34,800. That's why it's so important to pay attention to the fees you're paying and to choose the lowest-cost option that meets your investment objectives.

Warren Buffett doesn't fear stock market crashes

Many investors fear market crashes, and it's not hard to see why. Nobody enjoys watching the value of their investments plunge, and high volatility can certainly be scary.

However, Buffett has frequently advised investors that these are the best times to buy. "Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble," says Buffett. In fact, some of his most successful investments have come during and shortly after market panics. For example, Buffett's $5 billion investments in Goldman Sachs and Bank of America in the wake of the financial crisis turned out to be massive winners.

Having said that, market panics are only good for long-term investors who are in a position to take advantage. This is one big reason why Buffett likes to have a decent amount of cash on the sidelines at all times and why Berkshire avoids debt. As Buffett says, "Predicting rain doesn't count, building the ark does."

Warren Buffett doesn't follow the crowd

It's common knowledge that the central idea of investing is to buy low and sell high. However, our emotions tell us to do the exact opposite. When markets fall into a tailspin, it's human nature to want to sell before things get any worse. And when stocks seem to go nowhere but up and we see everyone else making money, that's when we're most tempted to get in on the action.

It's this type of emotionally charged mentality that causes most investors to underperform the market. According to a Dalbar report, the average equity index fund investor managed an annualized return of 5.29% over the 20-year period ending on Dec. 31, 2017, nearly 2 percentage points shy of the S&P 500's 7.2% annualized return over that time period. A big reason for the difference was emotional investment decisions.

Therefore, all of the value investing knowledge in the world won't do you a shred of good if you let your emotions get the best of you. "The most important quality for an investor is temperament, not intellect. You need a temperament that neither derives great pleasure from being with the crowd or against the crowd," Buffett once said.

Warren Buffett doesn't buy gold or other unproductive assets

Buffett has three different categories of investments:

  • Currency-denominated investments: This includes money market funds, CDs, bonds, and savings accounts.
  • Unproductive assets: This includes gold, other precious metals, cryptocurrencies, and more. These don't generate income or produce any goods or services but have the potential to increase in value over time.
  • Productive assets: This category is Buffett's preferred way to invest, and includes investments that generate income, produce assets, provide services, or otherwise generate value over time. Businesses are a good example of this, as are stocks, farmland, and real estate.

Obviously, things like cash and savings accounts aren't great investments. When accounting for inflation, these actually tend to lose value over time.

However, many investors are surprised to learn that Buffett doesn't invest in gold. His problem with gold and other precious metals is that they are only worth something because of hopes that they'll be worth more down the road -- in other words, their prices are driven purely by supply and demand, not because of an inherent ability to generate wealth, as in the case of productive assets.

"I have no views as to where it (gold) will be, but the one thing I can tell you is it won't do anything between now and then except look at you," Buffett says.

Cryptocurrencies are a category of unproductive assets that actually check two boxes on Buffett's stay-away list. Not only do cryptocurrencies not produce anything (bitcoin has often been referred to as digital gold), but they are also highly speculative and their prices are largely crowd-driven.

In reference to bitcoin in particular, Buffett has said, "Stay away from it. It's a mirage, basically... The idea that it has some huge intrinsic value is a joke in my view."

Warren Buffett doesn't speculate

When Buffett invests, he doesn't swing for the fences. He's fine hitting a series of a few hundred base hits instead of going for the home runs. As Buffett says, "It is not necessary to do extraordinary things to get extraordinary results." And Buffett has certainly achieved extraordinary results. By the end of 2018, Berkshire Hathaway stock had risen by 2,472,627% (that's not a typo) in the 54 years since Buffett took control of the company.

Because of this phenomenal performance, it's often assumed that Buffett must have taken some big risks that paid off well but, surprisingly, this isn't the case. Every investment Buffett makes is done because the value makes sense, there's a low probability of loss, and the business has a bright future.

Sure, speculation may work out some of the time. However, it's not a long-term strategy. "Half of all coin-flippers will win their first toss; none of those winners has an expectation of profit if he continues to play the game," says Buffett.

Warren Buffett's favorite way to use his time

It often surprises investors to learn that Buffett doesn't spend his workdays sitting in meetings, watching the financial news, or even analyzing stocks for the most part. Instead, the activity that takes up most of his time is sitting alone reading. "I just sit in my office and read all day," Buffett has said. "Read 500 pages like this every day. That's how knowledge works. It builds up, like compound interest. All of you can do it, but I guarantee not many of you will do it."

Reading this much may sound like a big undertaking, and it is, but Buffett has recommended several investing books over the years that can help you get started.

Buffett believes that the more knowledge an investor gains, the better positioned they'll be to make wise decisions and avoid making mistakes.