book.chapter Principle one: wise investment mindset

Power of Compounding Drives Growth Warren Buffett has mastered the art of buying and holding stocks for extended periods rather than actively trading them. His rationale for this long-term approach is that while stock prices may fluctuate in the short run, over longer time horizons there is a strong correlation between price and intrinsic value. No factor impacts the growth in value of a stock portfolio more powerfully over time than time itself. Wise investors therefore practice patience, choosing firms with strong fundamentals and allowing ample time for the stock price to rise steadily alongside the company's growing earnings. Compounding further amplifies the gains from outperforming the broader market. If the market advances 10% annually on average and an investor assembles a portfolio returning just 2-3 percentage points higher each year, the end result after 30+ years of compound growth will be tremendous. As Buffett puts it, "Time is the friend of the good business, the enemy of the poor." Watching excellent companies raise their sales and profits year after year is an investor's dream. Their intrinsic value consistently moves higher in tandem, with the stock price rising in lockstep. Over long periods, the magic of compounding kicks in, enabling one's net worth to snowball by ever greater absolute amounts annually. Or in Buffett's words, "The inescapable fact is that the value of an asset, whatever its character, cannot over the long term grow faster than its earnings do." Buy Low and Watch Costs To enhance returns beyond the general market's performance, Warren Buffett uses three straightforward strategies. First, he buys stocks only when their market price is below the actual value of the company, because these undervalued stocks will likely grow the most over time. Second, he invests in only as many companies as he can realistically monitor - typically 10 to 15 stocks maximum. This allows him to closely track each company's financials. Third, he eliminates all unnecessary costs by minimizing commissions, avoiding frequent trades, and automatically reinvesting dividends. These simple, common sense principles are often ignored by many investors, who make things more difficult for themselves. As Timothy Vick states, "The investor who can rationally assess a company's prospects and pounce when the price is right has an unbeatable edge over investors who simply follow the herd." Furthermore, Warren Buffett warns that "Investors have been so oversold on diversification that they put too little into companies they thoroughly know and far too much into others they barely understand. Buying a company without sufficient knowledge may be even riskier than having inadequate diversification." Buffett also emphasizes, "I put heavy weight on certainty. Risk factors don't make sense to me. It's not risky to buy securities at a fraction of their true worth." Maximize Gains Over Long Term Warren Buffett intensely avoids short term trading activities. To him, the ideal holding period for stocks is indefinitely, as rapid trading wastes money better used to build wealth over the long term. By buying and holding stocks for many years, not only are transaction costs eliminated, but continuity in evaluation methods exists. There's no need to frequently develop new ways to measure growth in value. Progress can simply be determined by year-to-year price changes. As Buffett states, "Most of our large positions are going to be held for many years, and the scorecard on our investment decisions will be provided by long term business results, not by prices on any given day." He adds, "Just as it would be foolish to focus unduly on short-term prospects when acquiring an entire company, we think it equally unsound to become mesmerized by near-term earnings when purchasing small pieces of a company." Buffett estimates that investors waste over $100 billion a year on trading costs and advice on whether they should trade their stocks. He laments, "In other words, investors are dissipating almost a third of everything the Fortune 500 is earning for them by handing it over to various types of 'helpers.'" Instead, Buffett wants shareholder-partners to profit from the underlying business, not from the "foolish behavior of their co-owners." As an investor himself, Buffett explains his edge: "I am a better investor because I am a businessman, and a better businessman because I am an investor." Finally, Buffett derides the legions of market predictors, stating, "Thousands of experts study indicators night and day, and they can’t predict markets with any useful consistency, any more than fortune tellers could tell the Roman emperors when the Huns would attack." Consider Future Opportunity Cost Warren Buffett is well known for being extremely frugal and conservative when it comes to his personal finances and business spending. What is less talked about is why he adopts this stance - he comprehends the opportunity cost of money spent rather than invested better than most. Opportunity cost considers what the future value of money could be instead of just its current value. For example, $100 compounded at 25 percent annually for 30 years would amount to $80,779. In essence, Warren Buffett realizes every dollar not unnecessarily spent today can transform into sizable capital down the road. From an opportunity cost view, all spending choices represent chances for future wealth to either be gained or lost. No one tells you to give up pleasures, hobbies or a fun afternoon at the ballpark purely to build up more money, however stellar investors like Buffett stay aware of the genuine costs of their activities. If you can compound capital at tremendous rates as Buffett can, it benefits you to turn into a saver rather than a consumer. Don't Create False Cause and Effect At its core, investing is a simple business activity - a statistical game of probabilities. The key is to quantify the risks, calculate the potential returns, and determine the likelihood of various outcomes. This allows an investor to quickly develop a stock selection system. However, many professional investors try to overcomplicate matters by incorporating endless complex variables or through extensive comparative analysis. Warren Buffett takes a different approach. He focuses on analyzing a company to estimate its most probable future earnings. As Charles Munger notes, extra complexity introduces extra room for error. Simple is often better. Rather than diversifying extensively as many advise, Buffett prefers to concentrate his portfolio, even if it raises risk. By intensely scrutinizing a business, he gains comfort with its economic characteristics before investing. Concentration raises the intensity of thinking about each investment. In Buffett's view, this focus decreases risk compared to a more diversified approach. In most fields, professionals bring specialized expertise that benefits laymen. But Buffett believes aggregate returns show that professional money managers fail to deliver value for the fees they charge. His concentrated yet straightforward analytical approach seeks to avoid these issues. The key is to keep investing simple rather than complex. Assess the business, judge the probabilities and make rational choices based on the facts. Avoid overthinking or overcomplicating the process. Concentrate on what matters for each potential investment. This is the essence of Buffett's proven approach. Stay Involved for Thirty Plus Years Warren Buffett is known for being an extremely patient investor. He plans to be intimately involved in Berkshire Hathaway's investment decisions for the foreseeable future. As a result, he does not feel pressure to act hastily when making investment choices. Buffett knows there will still be plenty of good investment opportunities available tomorrow and in the future. Similarly, investors should not act on an investment merely because a stock is temporarily undervalued or due to emotional reasons. Instead, investors should patiently wait for the market price of quality stocks to decline before making a purchase. For example, Buffett identifies stocks he would like to own over the next several years based on the company's value and earnings growth potential. He also sets a target share price at which he is willing to buy the stock. Buffett then waits patiently, holding onto his cash. If the stocks do not fall to his preset target price, he does nothing. He only buys when the stock passes the target price he previously determined. Buffett believes investors should avoid the temptation of buying stocks simply because they have spare cash available. More often than not, having extra cash lying around leads to investing mistakes. At the beginning of 1999, Buffett was holding over $35 billion in cash and bonds, ready to deploy into attractively priced investment opportunities. He was content to hold this large amount of money indefinitely until he found suitably priced companies to acquire. In contrast, most investors feel a need to immediately put their spare cash to work by purchasing shares in lower quality companies without thoroughly analyzing fundamentals. In investing, there are no "called strikes" - if you do not understand a company well enough to make an informed investment decision, even if the stock seems attractively priced, it is better to simply let the opportunity pass by rather than make an unwise investment. The stock market does not force investors to act, though it may tempt them to do so. By walking away from investment opportunities not fully understood or with unattractive valuations, investors can improve their "batting average". Truly great investment opportunities are rare, perhaps finding two dozen high quality prospects over a 20 year period. However, poor opportunities arise by the hundreds each day. Investors are better served by patiently waiting to swing big when the occasional "fat pitch" investment comes along at an extremely attractive price rather than chasing mediocre opportunities.