How to invest in the stock market (the Warren Buffet way)

For way too long I had way too much cash sitting in the bank, simply because I didn’t know what to invest it in. And it wasn’t because I didn’t do any research – I read a bunch of books, I asked around, and I even took a class, but I still didn’t know what I was doing. But now I do, and I’m writing this post to share what I’ve learned in the hope that others can save some trouble and blind alleys.



What I learned from Peter Lynch was that in the long term, investing in the stock market beats bonds hands-down, even if you were unlucky enough to invest at the peak right before the crash in 1929, you’d be back in the black in just a few years. Also, he encourages you to use your personal knowledge of companies and businesses when investing.



What I learned from William O’Neil was that that kind of speculation and trying to spot patterns in the movements of stock prices is something I don’t have the patience for. And the whole thing felt scammy – you’re encouraged to get his Investor’s Business Daily paper and software to really follow the system. No thank you.



But it wasn’t until I read the essays of Warren Buffet that things started to make sense. I didn’t even have to read the whole thing, his philosophy is so clear and simple. That’s what I’ve adopted. If you’re going to take advice from someone, Warren Buffet is not a bad mentor to choose.



Basically the idea is this:



First, invest only in good stocks, with good stocks being companies whose business you understand, ideally whose products you use, with competent and honest management, and with good long-term prospects, and buy at a good price. But if you have to give up on one of them, give up on low price. You should think of it as buying a part of the underlying company, as if you were a large corporation buying a subsidiary company.



Second, buy to hold at least 10 years. If a stock is not worth keeping for 10 years, it’s not worth owning for 10 seconds.



Third, ignore Mr. Market. Mr. Market is this character who comes to your door each day saying “I’ll buy your stock or sell you mine at so-and-so price.” Mr. Market is way too emotional. Some bad news, and he’s willing to sell at a ridiculously low price. A piece of good news, and his prices shoot up.



Markets fluctuate, and nobody can predict those fluctuations. And I certainly don’t have the time or patience to try. But in the long term, the stock price will tend to approximate the real value of the company. So if you buy shares in a company that has great long-term prospects and hold them for a long time, then the market’s price for the stock is almost guaranteed to increase.



One thing that happens when you realize that the stock’s worth is not its market price, and that is you get happy when the price of your stock drops. Why? Because that means you can get more of this wonderful stock even cheaper. It’s just like if you really enjoy a good wine, and the price drops. Great, I can get more for less money! Stocks are the same in the short term.



The final piece of the puzzle for me was that I was entering so late in the market cycle. What if I bought just as the market peaked? Is it just about to peak now? Someone must know! So I asked a friend who’s a professional stock broker, and she told me that – duh! – nobody knows. And nobody can know what’s going to happen tomorrow or in the next 6 months. I had this belief that everyone else knew, and I was the only one left out. But if she really had no clue, then no-one does.



So don’t try to time the market. At the end of the day, you have the cash when you have it, and unless you want to keep it in the bank as cash and let inflation and fees eat it up, you have to invest it in the market that is. And if you’re investing for at least 10 years, then you’re always better off putting it in stocks than bonds.



So I let go of trying to time my purchase, and just went for it. I picked 6 companies, half US, half Danish, that I like and admire and want to own part of. I’d prefer to narrow it down to even fewer, but there’s a silly law here that you can’t have more than 20% of your retirement funds in one stock. And now, when I have cash, I buy one of those, whatever the market price.



Okay, one thing I do do to time my buys. Whenever the stock price drops because Wall Street gets nervous over something that I think is bogus, I’ll check if I have spare cash lying around and go buy.



The nice thing about a long-term strategy like this is that you don’t have to watch the stock price on a daily basis. And when you do check up on the stock price, it’s without the emotional roller-coaster. Price dropped? Great! Let’s buy! Price went up? Great.



I got to test this lack of fear back in August during the subprime crisis, when my portfolio was down 5% from the purchase price, and it looked like I had indeed bought at the peak. And I really was completely calm. And after explaining a few things, my wife was, too :)

12 comments

I'm worried that with only six stocks your portfolio is not diversified enough. The historical fact that over long periods of time the market has always gone upwards has been valid only for the market as a whole (or a very broad portfolio of stocks), not for portfolios of six stocks. Aren't you going to purchase some (passively managed, buy-and-hold) mutual funds as well? Also, I would never put all my money in stocks not even in hugely diversified funds: a huge market crash followed by a depression is a scenario in which you may be forced to live off savings for a long time, selling large chunks of your portfolio at a fraction of its value.
By Branimir Dolički on Thu, Sep 27, 07 at 16:57 · Reply
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My $0.02. "averaging down" can be disasterous. Sometimes, the market is telling you that you *might* have missed something. Almost all good investors - whatever their approach - know themselves extremely well. They know how they will react ahead of time to different changes in the market, and when they need to execute, they push the button. Some people think success about the markets is knowing about other people. Their attention could be better focused closer to home. Money management is extremely important. There's plenty written about it so I'll just shut up now.
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@Branimir: I would invest in an index-based cheap mutual fund, and might do that, but there's still the choice of what market - Denmark, US, world - and there's also the problem that no-one is offering a low-cost index-based fund in Denmark. On the whole diversification issue, I've done that to some extent, but the flip side of diversification is "diworseification". I've chosen in favor of going with companies I believe in and know about, knowing that I'm running a risk. I'm not planning on selling any time soon.
By Lars Pind on Thu, Sep 27, 07 at 16:57 · Reply
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Joel Spolsky wrote that "The Random Walk Down Wall Street":http://www.amazon.com/Random-Walk-Down-Wall-Street/dp/0393062457/ is the only book you ever need to read about personal investing. Since I've so far obeyed that rule I can't really tell whether that's true or not, but I've found its theses pretty convincing. On a long time scale, not a single stock or investor has been consistently successful at beating the market. So if you count in the transaction costs, it's almost always best to stick to low-cost index funds (which might sound stupid during the current bull market).
By Jarkko Laine on Thu, Sep 27, 07 at 16:57 · Reply
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@Jarkko: That's entirely valid, and Warren Buffet says the same, but there are no such funds available in Denmark :(
By Lars Pind on Thu, Sep 27, 07 at 16:57 · Reply
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I've been learning to "let go" as well, recently. Had a surge of stock-mania a couple of months ago - which inevitably ended bad as Danish stock in general (my stock in particular) is down several percent since then. If you cannot handle the potential loss when "playing the market", stay off it - take the medium-long perspective. That's not really rocket science. I don't have time to keep up with financial trends and/or fiscal reports - and I think you have to be reasonably good at this in order to gain from quick buys and sells. Most of the market is psychology anyway - and fairly random. So you need to be good at gaining something from that last bit that is actually driven by sound economic data. Lars, do you have a link to that info on the Danish law on investment and retirement funds? I know of the possibility of doing my investing as a "rate pension" - but I haven't gone into it or seen the details...
By RasmusJ on Thu, Sep 27, 07 at 16:57 · Reply
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@RasmusJ: I don't. It's built into Danske Bank's web banking system, so when I tried to buy a single share of A. P. Møller, it refused because it was over the 20% limit. When I asked the bank about it, they said it was the law, not something they had dreamt up. That's all I know.
By Lars Pind on Thu, Sep 27, 07 at 16:57 · Reply
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Hm...I guess it makes sense from a societal perspective...evening out the effects across the economy. So, how does it determine the 20% limit?
By RasmusJ on Thu, Sep 27, 07 at 16:57 · Reply
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I don't know exactly, to be honest. When everything is in cash, it's easy, but I suspect it calculates it as 20% of the current market value of your stock + your remaining cash. Just guessing, though.
By Lars Pind on Thu, Sep 27, 07 at 16:57 · Reply
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Hm...thanks. That makes it difficult for me to transfer my stocks in one go. Think I'll have to ask my bank guy...
By RasmusJ on Thu, Sep 27, 07 at 16:57 · Reply
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Don't you guys use non-bank brokers? I can't imagine using a bank to buy/sell/trade but then again DK might be special in this way. Oh, and if a bank tells you that this or that is "the law", ask them which law. Banks are always trying to get people to believe that bank policy - or preference - is the law. Mostly rubbish of course. In the UK, banks pretty much get away with whatever they like by saying "We have to follow the **** law" where **** is "anti-terrorism", "data protection" or "anti-money-laundering". That's rubbish almost all of the time too.
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Mentally I move slowly towards the buy & hold theory. I've read Jeremy Siegels with great interest and now I'm getting deeper and deeper into the world of Warren Buffett. However, I have two concerns about the latter. First, it's very difficult to find companys that have a unique product (like Coca Cola and Gillette) and second, and most important, even Buffett sells stocks once in a while! All books and articles about Buffett is about how to buy stocks, but the real trick is when to sell (successess) and I have found no litterature about how Buffett sells his stocks. And that is really cruical!
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