Three Golden Rules From Warren Buffett’s Market Mentor

Three Golden Rules From Warren Buffett’s Market Mentor
Stéphane Renevier, CFA

almost 2 years ago4 mins

  • Markets are counterintuitively riskier when they rise than when they fall, so intelligent investors are contrarian, buying from pessimists and selling to optimists.

  • Behavioral biases are the biggest threat to your long-term success, so make sure you’ve got a process to limit their impact.

  • You’ll regularly be wrong, but you can still thrive by maximizing how well you do when you’re right and having a process to limit losses when you’re wrong.

Markets are counterintuitively riskier when they rise than when they fall, so intelligent investors are contrarian, buying from pessimists and selling to optimists.

Behavioral biases are the biggest threat to your long-term success, so make sure you’ve got a process to limit their impact.

You’ll regularly be wrong, but you can still thrive by maximizing how well you do when you’re right and having a process to limit losses when you’re wrong.

Mentioned in story

Warren Buffett is commonly referred to as the greatest investor of all time, and a touchpoint for investors the world over. But even the Oracle of Omaha had to learn the ropes from someone, and that someone was Benjamin Graham – the father of value investing. So while you could pick any of Graham’s quotes and learn something from it, there are three pearls of wisdom I think are particularly relevant to markets today…

“The intelligent investor is a realist who sells to optimists and buys from pessimists.”

Graham recognized that the stock market can be mercurial in the short term, with moods that swing from extreme pessimism to extreme optimism. But since stock prices tend to reflect a company’s fundamental value over time, he subscribed to the idea that you buy when investors are feeling bleak, and sell when they’re ecstatic.

See, buying when the market is pessimistic both boosts your long-term returns and reduces your risk. That’s because you can buy into a market for less when the market is already pricing in a negative outlook, which means you’ll benefit both from a larger margin of safety and from an improvement in sentiment. It may seem counterintuitive, but risk is actually lower when prices are dropping and markets are in chaos.

As for how to apply that to today, investors right now seem just as optimistic about US stocks as they are pessimistic about Chinese ones. Selling some of your US stocks and buying some Chinese stocks, then, might be a great way to profit from this first piece of Graham wisdom. US bonds are also arguably down in the dumps right now, and could be worth a look if you’ve got a long-term horizon.

“The investor’s chief problem – and even his worst enemy – is likely to be himself. In the end, how your investments behave is much less important than how you behave.”

The biggest threat to your portfolio, Graham argued, isn’t the likes of inflation or a deteriorating macroeconomic environment. It’s your emotions, which can push you to make the worst decisions, often at the worst possible times.

In fact, study after study has shown that our investment biases cloud our judgment. Feeling the pressure to trade after hearing someone brag about how much money they just made? That’s FOMO. Keen to buy the newest space travel stock? That’s framing bias. Doubling down on a stock that’s fallen, in hopes you’ll recoup those losses? That’s loss aversion and prospect theory.

Successful investors like Graham recognize this, arguing that understanding your own psychology is even more important to investing than choosing what to buy and what to sell. They also think overcoming your emotions is a lesson that applies just as much to active and passive investors. Anyone who’s seen their portfolio drop 50% knows how hard it is to just hold the line and resist their impulses.

So start by familiarizing yourself with the main behavioral biases, and identify the five that are most likely to throw you off track. Then look at your past investment decisions and see which ones kept you from achieving better results, keeping an eye out for patterns. Figure out how you can outsmart those biases by, for example, creating a behavioral checklist and asking yourself hard questions – like “Why am I really buying this stock?”.

“No matter how careful you are, the one risk no investor can ever eliminate is the risk of being wrong.”

If you want to make money, you have to take risks. And if you take risks, sometimes – often – you’ll be wrong. Even the investors with the best track records are wrong about half the time.

So what makes them so successful? Two things. First, they understand the importance of randomness in markets, and accept that not everything is in their control. Instead, they focus on what they can control: developing an edge that will slowly put them ahead over the long term, while carefully managing risk for when something unexpected happens.

Second, they make more money when they’re right than they lose when they’re wrong. If you’re right 50% of the time but make twice as much when you’re right, you may end up very rich. But if your average loss is bigger than your average gain, you’ll probably end up very broke.

So focus on the process, rather than the outcome. Position sizing, portfolio construction, and risk management are as important as generating good investment ideas. Then make sure you respect that process: document your investment decisions, so you can refer to them later. If you learn from every mistake you make, you’ll become a very successful investor indeed.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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