TwitterOrdinary investors can’t invest like Warren Buffett
May 23, 2010 by cook · 2 Comments
A lot of investment advice points to Warren Buffett as a source to draw wisdom from. Without question, Buffett is one of the most accomplished investors ever. That said though, there are some serious fallacies to pointing to Buffett as an example for ordinary investors. Here’s why.
An often cited quote of Buffett is that his number one rule is “never lose money.” If only things were that simple. This is just too Zen for me. A lot of financial writers in my opinion misunderstand how Buffett is investing, and a lot of his strategies simply will not work for an ordinary investor.
How Buffett invests
When Warren Buffett invests, he often does not buy shares in a company over an exchange. Instead, he buys the entire company outright. Then, he works with the company’s board of directors to make sure that the company is running as efficiently and smoothly as possible.
Can you walk into a board room and tell the directors how to restructure their company? No? Then you’re not investing like Warren Buffett. Sorry to break the bad news.
The “buy and hold” fallacy
It’s pretty often that I hear from investors who have lost money that they are fine with their losses, since they are holding their investments over a long time horizon, and they believe that in time, they will recoup their losses. Buffett has often been attached to the buy and hold school.
There’s a big problem with this line of thinking. He may buy turnaround stories, but as I wrote earlier, Buffett has the resources to help turn those companies around. If you’re an ordinary person saving in an IRA…you don’t have those resources. Buy and hold can a legitimate strategy, but it is not legitimate if you are holding on to a loser indefinitely in the false hope that it will one day recover.
The index fund fallacy
Buffett has been quoted as promoting the use of index funds for ordinary investors. For investors seeking to park money, this may be a legitimate strategy, although I am definitely a proponent of a more active approach (the debate between active and passive management warrants an article of its own entirely).
That said, Buffett’s strategy is anything but indexing. His acquisitions are very much actively targeted, and he takes a very active role in the management of his acquired companies. His investment strategy is more like a private equity firm than an index fund. Passive indexing might have some use for ordinary investors, but investors should not kid themselves that they are investing like Warren Buffett by using index funds.
Don’t look at what someone says. Look at what they actually do.
Conclusion
Warren Buffett is certainly a great investor, but he is often misunderstood. Frankly, Peter Lynch might be a better example to draw from for ordinary investors. An ordinary investor cannot buy an entire railroad company and then work with the board to streamline it. Investors and market enthusiasts should certainly study Buffett, but they need to make sure that they see the forest from the trees.
-Alex Cook
Berkshire, albeit a holding company, does not always buy a company outright. In fact, Berkshire has an entire portfolio of equity securities. For example, according the the most recent SEC filings, Berkshire has decreased its stake in Kraft Foods (by 23%) and Procter & Gamble (down ~10%). In addition, Buffett has increased stakes in Iron Mountain and Republic Services — suffice to say, Berkshire hasn’t bought these companies “outright.” Additionally, Buffett bought increasing share amounts in Burlington Northern before he bought the whole thing. Lastly, Buffet had an incredible record before he took over Berkshire, and made it a holding company.
Buffett is first and for most a value investor. Part of the value investing philosophy is to look where others are not looking (because that is where the market inefficiencies are, and where stocks selling at a discount can be found!). These stocks include, but are not limited to, companies that are oversold due to weak earnings that will stabilize in the long-run (the extreme being a “turnaround story”).
Buy and Hold is perhaps, in my mind, the only strategy to could work for the “ordinary investor.” And if you disagree, I’d love to hear your thoughts. Sure, sometimes the market doesn’t recognize the true value of undervalued stock, but over the long-run it should (through improved earnings, growth of assets and book value, or a catalyst). Notice is say “should,” not always; but it happens enough times to give value investing credibility.
Peter Lynch’s books also endorse the value philosophy – although he puts it in laymen. Lynch says to look where others are not looking by picking out boring companies in unattractive industries (Waste Management Co. being his primary example, and one of his most profitable stocks at Fidelity). “Invest in what you know,” is just another way of stating that your analysis should be thorough. In his book, One of Wall Street, Lynch also states that his investing methodology is similar to Buffets.
The real reason why no one has managed to emulate Buffett’s success is because of his uncanny ability to (1) find companies he’s interesting in owning, (2) value them, (3) and be disciplined enough to only buy them when the market valuations are attractive. All three of these a required to do well,and it is difficult – something no “ordinary” investor can do.
Sorry I haven’t had a chance to get back to your comment yet; things have been a bit hectic on my end.
You make good points, and I do agree with what you’re saying. One past can’t really sum up the debate between active and passive management, and yes you are correct that Buffett does hold on to a portfolio.
The main thing that I was trying to address, possibly inelegantly, is that some investors and popular financial “advisors” are promoting following Buffett’s strategies while at the same time espousing strategies that are very un-Buffett-like (I just made up a new word). Buffett is a value investor. Buying and holding onto index funds, as some Buffett fans and even Buffett himself have suggested, isn’t really a value strategy at all.
-Alex Cook