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Warren Buffett's 3 Investing Rules
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Today, we're going to look at Warren Buffett's 3 investing rules.
In Buffett's 1994 letter to shareholders, he covered a number of interesting topics including capital allocation, compensation, & investing mistakes…
But probably none as interesting as the one he addressed near the end of his nearly 10,000-word letter:
His approach to investing in stocks.
More specifically, his 3 broad rules that govern how he invests.
Let's check it out.
Rule #1: Few Investments, Easily Explainable Investments
Investors have only so much time to keep on top of their investments…
That's a big reason why Buffett & Charlie Munger believe in investing in fewer, high-conviction investments.
Munger explains:
“Phil Fisher believed in concentrating in about 10 good investments and was happy with a limited number. That is very much in our playbook. He believed in knowing a lot about the things he did invest in. And that’s in our playbook, too.”
Buffett echoed this in the 1994 letter. And expanded on his criteria for investing in stocks:
"Our investments continue to be few in number and simple in concept: The truly big investment idea can usually be explained in a short paragraph. We like a business with enduring competitive advantages that is run by able and owner-oriented people. When these attributes exist, and when we can make purchases at sensible prices, it is hard to go wrong (a challenge we periodically manage to overcome)."
Let's unpack that:
First, Buffett likes investments that are easily explainable. When he comes across a good investment, he wants it to be obvious:
Because it's so obvious, the thesis is pretty easy to explain.
Next, Buffett touches on the characteristics of the businesses he prefers. He not only wants a business with a competitive advantage, what Buffett calls a "Moat," but an advantage that's nearly certain to endure over time. Because, as Buffett put it:
"The products and services that have wide, sustainable moats around them are the ones that deliver rewards to investors."
In addition, he wants a company ran by effective management as well. While he's previously agreed with Peter Lynch, who said he wants a business so great that an idiot could be able to run it, Buffett prefers capable management. Owner-oriented management that has skin in the game (or compensation tied to performance).
Of course, Buffett wants this all at a great price. So we have to be patient for prices to swing in our favor...
Finally, note that Buffett says when we can purchase a company like this at a great price, "it is hard to go wrong." That's a great insight into how we should set our expectations…
Rather than default to imagining how great an investment might turn out, we simply recognize that we've positioned ourselves well against adversity. Setting our expectations this way can help minimize emotional swings (an excellent example of using the Inversion principle).
Buffett ends his passage with some self-deprecatory humor—explaining that despite knowing these investment criteria, he still periodically manages to slip up. It reminds me of Charlie Munger's quote:
"It's a good habit to trumpet your failures and be quiet about your successes."
Self-deprecation is a great habit for investors: checking overconfidence & keeping us humble.
Rule #2: We Don't Get Extra Credit For Complexity
Oftentimes, we can slip into believing more complexity around an investment improves its appeal—and to an extent that can be true:
More complex businesses, industries, and investments are more likely to be underfollowed. So, they're more likely to be underpriced…
But if there are other companies that are easier-to-understand, and potentially equally undervalued, it makes sense to focus on them:
"Investors should remember that their scorecard is not computed using Olympic-diving methods: Degree-of-difficulty doesn't count. If you are right about a business whose value is largely dependent on a single key factor that is both easy to understand and enduring, the payoff is the same as if you had correctly analyzed an investment alternative characterized by many constantly shifting and complex variables."
We don't get extra credit for making things more complex than they need to be.
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Rule #3: Don't Try To Time Investments—Price Them
A recurring theme among the best investors is they respect their "duality of control." In other words, they mind what's outside & inside their control.
A great number of factors in investing are outside our control. As such, we must focus on the few levers we do control. For example:
Outside of our control:
Interest Rates
Economies
Markets
Within our control:
Following our investing rules
Requiring a margin of safety
Being patient
Guessing the direction of markets and economies, 2 things outside of our control, is hardly wise or predictable.
But researching until we find predictable businesses at sensible prices—that's within our control.
Buffett explains his third rule:
"We try to price, rather than time, purchases. In our view, it is folly to forego buying shares in an outstanding business whose long-term future is predictable, because of short-term worries about an economy or a stock market that we know to be unpredictable. Why scrap an informed decision because of an uninformed guess?"
Bonus: Where To Begin Searching For The "Next Big Thing"
Buffett finished his section on investing in stocks by giving us one more bonus tip as a reminder…
As investors, we tend to always look for the "next big investment opportunity."
Especially in the age of A.I., the appeal of new businesses can be incredibly powerful.
But sometimes, we don't have to look that far:
"Before looking at new investments, we consider adding to old ones. If a business is attractive enough to buy once, it may well pay to repeat the process. We would love to increase our economic interest in See's or Scott Fetzer, but we haven't found a way to add to a 100% holding. In the stock market, however, an investor frequently gets the chance to increase his economic interest in businesses he knows and likes. Last year we went that direction by enlarging our holdings in Coca-Cola and American Express."
Conclusion
Those are Warren Buffett's 3 investing rules from his 1994 shareholder letter. Let's recap:
Few investments, easily explainable investments.
We don't get extra credit for complexity.
Don't try to time investments. Price them.
Bonus: Your next big investment might simply be adding to a current holding.
Well, that's all for today.
I hope you found this helpful.
See you next Saturday.
Two resources I think you might like:
Book Summaries: One of the most important lessons from Charlie Munger is to strive to become a little bit wiser each day. To accelerate my learning on everything from investing & decision-making to negotiating & habit-building, I use Blinkist (Thank you to the Blinkist team and their affiliate program for helping keep this newsletter free to the reader). Blinkist offers easily readable book summaries to help you get the most valuable ideas from the most popular books. You can check out Blinkist here.
Mental Exercises: To paraphrase Morgan Housel, the common factor among elite investors is they have complete control over the space in between their ears. Financial news networks and social media can create a lot of "noise" for investors. To stay focused and calm, I like to use Headspace (I don't receive any compensation from Headspace currently). Headspace offers mindset and breathing exercises to help you keep control over the space between your ears. You can check out Headspace here.
Disclaimers
This material is not investment advice. No responsibility for loss occasioned to any person or corporate body acting or refraining to act as a result of reading this material can be accepted by the publisher. Additional disclaimers here.
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