Millions of investors chase Warren Buffett. Tens of thousands attend Berkshire Hathaway's annual shareholder meetings. Wealthy fans bid millions of dollars to have lunch with him. His appearances on CNBC bring trading floors to a halt. People want to know what he's thinking. Why he's different. What secret has made him so much more successful than anyone else.
What's interesting -- and a little ironic -- is that Buffett has never held back what his secret is. As he recently told PBS:
I read a book, what is it, almost 60 years ago roughly, called The Intelligent Investor and I really learned all I needed to know about investing from that book, and in particular chapters 8 and 20 ... I haven't changed anything since.
One book. Two chapters. Legendary success.
You'd think such precisely guided advice would draw more attention. Not only has Buffett filtered his success down to one book, he's even listed the two specific chapters on which he built his wisdom. He's making this almost embarrassingly easy for us.
What bits of sage advice do these two chapters -- published in 1949 by Buffett's early mentor Ben Graham -- hold? Here are key points from each one.
Chapter 8: The Investor and Market Fluctuations
Markets go up. Markets go down. Most of us accept this fact until we experience the latter, at which time we throw up our hands and consider the whole thing a sham.
That kind of behavior is what Chapter 8 is all about: dealing with market movements, and how fundamental they are to investing success.
We have a tendency to become confident and invest the most money after stocks have logged big gains, and vice versa -- selling in panic after big drops. Two seconds of logical thought will tell you this isn't rational. Yet we do it over and over again.
Buffett built his success on exploiting the market's movements rather than following them with lemming-like obedience. He bought stakes in companies like American Express (NYSE:AXP) and Washington Post (NYSE:WPO) when the market wanted nothing to do with them. He sat on his hands and laughed when companies like eBay (NASDAQ:EBAY) and Intel (NASDAQ:INTC) soared during the dot-com boom, ignoring heckles about his technophobic incompetence. It's truly as simple as "being greedy when others are fearful, and fearful when others are greedy."
Here's how Graham puts it in Chapter 8:
The true investor scarcely ever is forced to sell his shares, and at all other times he is free to disregard the current price quotation. He need pay attention to it and act upon it only to the extent that it suits his book, and no more. Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons' mistakes of judgment.
Chapter 20: Margin of Safety as the Central Concept of Investment
Graham opens Chapter 20 with a potent message:
In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, 'This too will pass.' Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.
We have an overwhelming urge to expect certainty, but we live in a world that is anything but. Forward-looking projections of a stock's value are based on assumptions, prone to wild miscalculations and unforeseen events. And by prone, I mean 100% assured.
There's only one surefire solution to this: Pay far less for stocks than your estimate of value, leaving room for error. That's a margin of safety. It's giving yourself room to be wrong, knowing that you probably will be. Think a company is worth $50 a share? Great. Don't pay more than $25 for it. Think a company could earn $2 per share next year? Great. Set yourself up so that you'll profit if it only makes a buck. There has to be a wide range of acceptance between the projected and the potential.
One stock that might epitomize the opposite of a margin of safety is Citigroup (NYSE:C). People want to own it because it's gone up a lot, and their frontal lobes tell them to hold out for more fun. Last month, shares were bid up to a market cap equivalent to the one the bank boasted when it was making gobs of money. That's ridiculous. Investors are putting their hope and money on the idea that Citi will suddenly return to the days when it was profitable like no one's business -- an outcome that's far from certain, or even remotely likely.
There's no margin of safety in Citigroup, or other suddenly popular financial names like Bank of America (NYSE:BAC) or AIG (NYSE:AIG): People are betting heavily on one outcome and will find themselves quite disappointed at the first sign of anything else.
Moving on
These lessons might seem basic and dull. They are. Yet too many investors fail to implement them. Buffett obviously isn't the only one who's read The Intelligent Investor -- he's simply put its lessons and theories to work in a habitual manner.
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This article was first published on July 17, 2009. It has been updated.
Fool contributor Morgan Housel owns shares of Berkshire Hathaway. Berkshire Hathaway and eBay are Motley Fool Stock Advisor selections. American Express, Berkshire Hathaway, and Intel are Motley Fool Inside Value selections. The Fool owns shares of Intel and Berkshire Hathaway, and it has a disclosure policy.
