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 :)