We can't all have Warren Buffett's investing success, but we can all improve our performance with his wisdom. Buffett embraces a handful of principles that anyone can use to unlock long-term gains. Keep these in mind when you're building and managing your retirement account.
1. Consider fundamentals and cash flows
Buffett has been heavily influenced by famed investor Benjamin Graham, who many consider to be the father of value investing. Graham's approach centered on finding the intrinsic value of a stock, which was based on calculating the current value of a company's future profits. If the intrinsic value of a company was reliably higher than its share price, then there was a good chance that the stock would appreciate.
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There are important limitations to intrinsic valuation methods, such as discounted cash flows or residual earnings models. These calculations are hard to apply to growth stocks and unprofitable businesses. Even in ideal situations, these methods require several assumptions that lead to high margins of error.
Regardless of those drawbacks, value investing can teach us valuable (ahem) lessons. At some point, the value of equity in a business usually reflects the cash flows that it produces. Shareholders can get cash returned through dividends or an acquisition, and the current value of the stock should equal the expected future value of those cash-out events, discounted based on the time value of money.
Of course, a stock is worth whatever market participants are willing to pay for it. That can be difficult to predict at any given time. However, Buffett has shown that there are ways to estimate future stock valuations with more accuracy. Pay attention to growth and cash flow. Companies that are unable to grow or reliably produce cash profits tend not to appreciate in the long term.
As you identify stocks for your IRA, make sure that your expectations are connected to the performance of the underlying businesses.
2. Look for an economic moat
Economic moats are characteristics that shield businesses from competition. Companies with wide economic moats have sustainable competitive advantages. This helps them grow and maintain robust profit margins. Buffett has often chosen stocks of companies that exhibit substantial economic moats compared to their industry peers.
There are a variety of economic moats. Technology or proprietary processes could be protected by patents or trade secrets, preventing rivals from replicating a valuable offering. The network effect enhances the value of a product or service based on the quality of the user base, creating a huge obstacle for challengers. Some incumbents offer services that would be very expensive to abandon for an alternative. This keeps customers locked in, and it creates a huge hurdle for competitors hoping to steal market share. Some moats are simply built on brand strength, in which customers perceive reliable quality based on reputation.
Consider doing what Buffett does and adding stocks to your IRA that have wide economic moats. If you have a 401(k) that only offers ETFs and mutual funds, consider funds that focus on companies with wide moats and sizable profits.
3. Don't chase hyped-up stocks
Buffett is well-known as a value investor, but it's important to recognize the distinction between value investing and value stocks. Value investing specifically refers to the relationship between a company's market cap and its expected future cash flows. Value stocks, on the other hand, are generally stocks with low valuation ratios.
That said, value investing strategies focus on identifying stocks that are priced too low, and these methodologies can be difficult to apply to growth stocks. This naturally leads to value stocks in many cases. It's not necessarily bad to invest in a company with a high P/E ratio, but it's important to view that ratio in the context of future cash flow potential. Sometimes investors are gripped by FOMO or exuberance, and they stop thinking about fundamentals. This notably happened during the dot-com bubble and the COVID-19 bull market. People didn't want to get left behind, and there was a gold rush centered on exciting new technologies. Valuations charged to unreasonable levels, at which asset prices assumed 10-20 years of consistent strong performance.
You won't see Buffett chasing hyped-up stocks with high valuations, as it's generally not a successful strategy to do so. It's fine to have significant exposure to growth stocks, and it's OK to ride your winners. That said, it's prudent to mix in some value investments to balance your portfolio. It's also a good idea to periodically review your retirement account to make sure that you're not exposed to equities with ballooning, unsustainable valuations. That's especially true if you have a Roth or traditional IRA with individual stock holdings.
4. Invest for the long term
Buffett doesn't try to time the market, and you shouldn't, either. Stocks are influenced by all sorts of factors in the short term, many of which are beyond the control of investors or the company's management. Market crashes happen and volatility is a natural part of investing.
If your retirement account is properly allocated, it should deliver reliable long-term growth, even if it's unpredictable in the short term. Most people time the market by selling after they've already taken losses, then buying again once it's already starting to rise again. That's a great way to lock in losses and miss out on gains.
Instead of attempting to time the market, stick to a long-term strategy, and consistently contribute to those assets over time. Most people fund their 401(k) a little bit with each paycheck. That's a sneakily simple way to replicate Buffett's approach. Don't overthink it. Playing it by the book is usually the smartest move with your retirement savings.
