Warren Buffett’s investment advice is timeless. I have lost track of the number of investing mistakes I have made over the years, but almost all of them fall into one of the 10 buckets of investment tips given by Warren Buffett below.
By keeping Buffett’s investment advice in mind, investors can sidestep some of the common traps that damage returns and jeopardize financial goals.
Not surprisingly, Warren Buffett certainly practices what he preaches. Buffett’s portfolio of high dividend stocks is perfectly aligned with his guiding principles.
Warren Buffett’s Investment Advice
After much deliberation, I settled on my 10 favorite Warren Buffett investing tips in the list below.
Each nugget of wisdom is supported by at least one of Warren Buffett’s quotes and is helpful for investors seeking to find safer stocks. Let’s dive in.
1. Invest in what you know…and nothing more.
One of the easiest ways to make an avoidable mistake is getting involved in investments that are overly complex.
Many of us have spent our entire careers working in no more than a handful of different industries.
We probably have a reasonably strong grasp on how these particular markets work and who the best companies are in the space.
However, the far majority of publicly-traded companies participate in industries we have little to no direct experience in.
“Never invest in a business you cannot understand.” – Warren Buffett
This doesn’t mean we can’t invest capital in these areas of the market, but we should approach with caution.
In my view, the far majority of companies operate businesses that are too difficult for me to comfortably understand. This is a key point that I follow with my investment philosophy.
I’ll be the first one to tell you that I cannot forecast the success of a biotechnology company’s drug pipeline, predict the next major fashion trend in teen apparel, or identify the next technological breakthrough that will drive growth in semiconductor chips.
These types of complex issues materially affect the earnings generated by many companies in the market but are arguably unforecastable.
When I come across such a business, my response is simple: “Pass.”
There are too many fish in the sea to get hung up on studying a company or industry that is just too hard to understand. That is why Warren Buffett has historically avoided investing in the technology sector (aside from his purchase of IBM).
If I cannot get a reasonable understanding of how a company makes money and the main drivers that impact its industry within 10 minutes, I move on to the next idea.
Of the 10,000+ publicly-traded firms out there, I estimate that no more than a few hundred companies meet my personal standards for business simplicity. Some sectors are better for dividend income than others as well.
Peter Lynch once said, “Never invest in an idea you can’t illustrate with a crayon.”
Many mistakes can be avoided by staying within our circle of competence and picking up a Crayola.
2. Never compromise on business quality
While saying “no” to complicated businesses and industries is fairly straightforward, identifying high quality businesses is much more challenging.
Warren Buffett’s investment philosophy has evolved over the last 50 years to focus almost exclusively on buying high quality companies with promising long-term opportunities for continued growth.
Some investors might be surprised to learn that the name Berkshire Hathaway comes from one of Buffett’s worst investments.
Berkshire was in the textile manufacturing industry, and Buffett was enticed to buy the business because the price looked cheap.
He believed that if you bought a stock at a sufficiently low price, there will usually be some unexpected good news that gives you a chance to unload the position at a decent profit – even if the long-term performance of the business remains terrible.
With more years of experience under his belt, Warren Buffett changed his stance on “cigar butt” investing. He said that unless you are a liquidator, that kind of approach to buying businesses is foolish.
The original “bargain” price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces. These types of companies also usually earn low returns, further eroding the initial investment’s value.
These insights led Buffett to coin the following well-known quote:
“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” – Warren Buffett
One of the most important financial ratios that I use to gauge business quality is return on invested capital.
Companies that earn high returns on the capital tied up in their business have the potential to compound their earnings faster than lower-returning businesses. As a result, the intrinsic value of these enterprises rises over time.
“Time is the friend of the wonderful business, the enemy of the mediocre.” – Warren Buffett
High returns on capital create value and are often indicative of an economic moat. I prefer to invest in companies that generate high (e.g. 10-20%+) and stable returns on invested capital.
Instead of giving in to the temptation to buy a dividend stock yielding 10% or snap up shares of a company trading for “just” 8x earnings, be sure you are comfortable with company’s business quality.
3. When you buy a stock, plan to hold it forever
Once a high quality business has been purchased at a reasonable price, how long should it be held?
“If you aren’t thinking about owning a stock for ten years, don’t even think about owning it for ten minutes.” – Warren Buffett
“Our favorite holding period is forever.” – Warren Buffett
“If the job has been correctly done when a common stock is purchased, the time to sell is almost never.” – Phil Fisher
Warren Buffett clearly embraces a buy-and-hold mentality. He has held some of his positions for a number of decades.
Why? For one thing, it’s hard to find excellent businesses that continue to have a bright long-term future (Buffett runs a concentrated portfolio for this reason).
Furthermore, quality businesses earn high returns and increase in value over time. Just like Warren Buffett said, time is the friend of the wonderful business. Fundamentals can take years to impact a stock’s price, and only patient investors are rewarded.
Finally, trading activity is the enemy of investment returns. Constantly buying and selling stocks eats away at returns in the form of taxes and trading commissions. Instead, we are generally better off to “buy right and sit tight.”
“The stock market is designed to transfer money from the active to the patient.” – Warren Buffett
For investors seeking more information, I wrote an article covering the sell criteria I use to manage our dividend portfolios: When Should I Sell My Stocks?
4. Diversification can be dangerous
I previously wrote a piece about how to build a dividend portfolio and touched on the topic of diversification. In my view, individual investors gain most of the benefits of diversification when they own between 20 and 40 stocks across a number of different industries.
However, many mutual funds own hundreds of stocks in a portfolio. Warren Buffett is the exact opposite. Back in 1960, Buffett’s largest position was a whopping 35% of his entire portfolio!
Simply put, Warren Buffett invests with conviction behind his best ideas and realizes that the market rarely offers up great companies at reasonable prices.
“You will notice that our major equity holdings are relatively few. We select such investments on a long-term basis, weighing the same factors as would be involved in the purchase of 100% of an operating business: (1) favorable long-term economic characteristics; (2) competent and honest management; (3) purchase price attractive when measured against the yardstick of value to a private owner; and (4) an industry with which we are familiar and whose long-term business characteristics we feel competent to judge. It is difficult to find investments meeting such a test, and that is one reason for our concentration of holdings. We simply can’t find one hundred different securities that conform to our investment requirements. However, we feel quite comfortable concentrating our holdings in the much smaller number that we do identify as attractive.” – Warren Buffett
When such an opportunity arises, he pounces.
“Opportunities come infrequently. When it rains gold, put out the buck, not the thimble.” – Warren Buffett
On the other end of the spectrum, some investors excessively diversify their portfolios out of fear and/or ignorance. Owning 100 stocks makes it virtually impossible for an investor to keep tabs on current events impacting their companies.
Excessive diversification also means that a portfolio is likely invested in a number of mediocre businesses, diluting the impact from its high quality holdings.
“Diversification is a protection against ignorance. It makes very little sense for those who know what they’re doing.” – Warren Buffett
Perhaps Charlie Munger summed it up best:
“The idea of excessive diversification is madness.” – Charlie Munger
How many stocks do you own? If the answer is more than 50-60, you might seriously consider slimming down your portfolio to focus on your highest quality holdings.
5. Most news is noise, not news
There is no shortage of financial news hitting my inbox each day. While I am a notorious headline reader, I brush off almost all of the information pushed my way.
The 80-20 rule claims that around 80% of outcomes can be attributed to 20% of the causes for an event.
When it comes to financial news, I would argue it’s more like the 99-1 rule – 99% of the investment actions we take should be attributed to just 1% of the financial news we consume.
Most of the news headlines and conversations on TV are there to generate buzz and trigger our emotions to do something – anything!
“Owners of stocks, however, too often let the capricious and often irrational behavior of their fellow owners cause them to behave irrationally as well. Because there is so much chatter about markets, the economy, interest rates, price behavior of stocks, etc., some investors believe it is important to listen to pundits – and, worse yet, important to consider acting upon their comments.” – Warren Buffett
The companies I focus on investing in have thus far withstood the test of time. Many have been in business for more than 100 years and faced virtually every unexpected challenge imaginable.
Imagine how many pieces of gloom-and-doom “news” originated over their corporate lives. However, they are still standing.
Does it really matter if Coke missed quarterly earnings estimates by 4%?
Should I sell my position in Johnson & Johnson because the stock has slid by 10% since my initial purchase?
With falling oil prices reducing demand for some of GE’s products, should I sell my shares?
The answer to these questions is almost always a resounding “no,” but stock prices can move significantly as these matters arise. Financial news outlets also need to blow up these issues to remain in business.
“Remember that the stock market is a manic depressive.” – Warren Buffett
As investors, we need to ask ourselves if a news item truly impacts our company’s long-term earnings power.
If the answer is no, we should probably do the opposite of whatever the market is doing (e.g. Coke falls by 4% on a disappointing earnings report caused by temporary factors – consider buying the stock).
The stock market is an unpredictable, dynamic force. We need to be very selective with the news we choose to listen to, much less act on. In my opinion, this is one of the most important pieces of investment advice.