How Warren Buffett Beats The ‘Financial Experts’ : Adam Khoo

Fund managers and financial experts often advise clients to broadly diversify their money across many different financial instruments such as stocks, bonds, currencies & money market funds. The logic is that by spreading your money into different areas, you reduce your risk. Master Investors like Warren Buffett believe that although broad diversification reduces risk, it also reduces any potential of return.

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If you invest in 50 stocks, then for your portfolio to double in value, you must find 50 stocks that double in value. That is almost impossible! At the same time, by investing in so many companies and instruments, it is impossible for you to become an expert in anything. He believes that people diversify into everything to protect themselves against their own ignorance! It’s like asking the great tenor Luciano Pavarotti to diversify into Heavy Metal, Country & Western, Techno, Hip Hop and R&B in order to reduce his risks in case he does not do well in Opera.

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Instead, Warren Buffett believes in focusing all his money into a few, very well selected stocks that he knows will double in value. He believes that an investor must only invest into a few companies that he understands very well and can track very closely. He calls it investing within your circle of competence. Does this mean that you should bet your entire savings on one or two companies? Of course not! That is too dangerous. It is still important to spread your money across at least 8-10 stocks that you know inside out. However, once you buy more than that, it becomes harder to invest intelligently.

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Fund managers & the investing public tend to be very short-term performance focused. They tend to buy a stock when there is lots of good news (i.e. economy is strong, company’s earnings beats forecast, launch of a new product etc) that pushes the stock price higher and higher. Consequently, they tend to jump out of a stock when bad news sends the stock price falling. Actually, there is nothing really wrong with this approach.

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By doing so, you are investing along with the trend. This strategy is known as ‘momentum investing’. However, the danger with ‘momentum investing’ is that it is all about timing and the ability to read into investor psychology. The trouble is that most average investors who lack these skills jump in too late (after all the professional funds have entered), when the stock price has already risen near its peak! Sure enough, they find that the stock prices start falling the day after. Out of fear and panic, they sell the stock and end up with a loss. This is why the typical investor always experiences their stock price falling soon after they have entered the market.

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On the other hand, value investors like Warren Buffett take a Contrarian approach. They go against the market psychology and trend. They buy the stock of a good company when nobody else wants it. This is when the stock price is extremely low and attractive. They then wait patiently for the stock to come into favour again. When optimism returns and the crowd starts to push the shares of the company higher and higher, the value investor will then sell his shares at a nice profit.

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While many financial experts preach the concept of having to take high risks in order to make high returns, master investors like Warren Buffett believe that it does not take high risks to make high returns. Instead, it takes a high level of financial and business competence to make high returns! In fact, he will only make an investment when there is a very low risk of loss and a very high probability of gain. He does this by only investing in companies that are selling way below their true value. In this way, he gives himself a wide margin of error. Which means even if his calculations are off, he will still be making money.

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The trouble with professional managers of mutual funds is that they are pressured to invest 80% of their cash into the market, even when there is nothing attractive to buy. This happens after a prolonged bull-run when stock prices are so high that companies are way overvalued. On the other hand, Buffett would happily keep all his money in cash and only invest when there is a golden opportunity. This is exactly what happened in 1999-2000 (stock prices were insanely overvalued) when Buffett was criticized for not making a single investment and keeping all his money in cash. Buffett only moved in to buy after 2001, when stock prices had crashed and companies could be bought for a steal.

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