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Lessons From Warren Buffett
The Smart Profits Report: Issue #425
Tuesday, May 29, 2007
Lessons From Warren Buffett: Two Ways To Avoid Getting Burned By “Competition-Style” Investing
By D. R. Barton, Jr.
Quantitative Analyst, Mt. Vernon Research
When this guy speaks, economists, investors, and the financial media across the globe sit up and take notice. He’s one of the most well-known, successful, and respected investors in the world - and with a personal fortune of $44 billion, one of the wealthiest.
So it’s not surprising that his investment decisions almost always make news. Most of them simply notch up more wealth for him, his shareholders, and the folks who take heed of him.
I’m talking about Mr. Warren Buffett, the 76-year old brains behind Berkshire Hathaway. But some people are questioning the merit of one of his recent decisions. Are they right, will we be learning lessons from Warren Buffett, or will he prevail? Let’s take a look…
“The Apprentice”… Warren Buffett Style
What would you do with $5 billion in two years?
At the annual Berkshire Hathaway shareholder meeting earlier this month, Buffett surprised attendees by announcing that he will search for his successor by jumping on the reality show bandwagon.
Buffett will select three or four top candidates for the position and give them $5 billion to manage for two years. The winner of the $5 billion challenge will get the nod to run Berkshire Hathaway.
On the surface, it sounds like a nifty idea. And while it won’t be on TV (at least not yet), Buffett’s “reality show” has the makings of great drama. But if you look a bit deeper, this type of selection strategy has some serious flaws, because of the mistakes and rash decisions that such “competition-style” investing can trigger. And it’s got some important lessons for us, too…
Win At All Costs? Not So Fast…
Warren Buffett’s selection process has obviously caught the eye of the media, most notably in Austan Goolsbee’s New York Times article, where he likens Buffett’s tactics to Donald Trump’s reality show, “The Apprentice.”
There’s certainly one aspect of this that is a big concern: Is a “win at all costs” reality show strategy the appropriate way to invest or choose an investment manager - especially one running the massive Berkshire Hathaway operation?
After all, if one of the contestants makes $3 more (on a $5 billion investment portfolio) over the course of the two years, is that significant? But the key issue here is that this type of competition easily encourages participants to take undue risks in order to be first past the post.
For the record, I’m sure Mr. Buffett and his staff has taken these issues (and plenty more) into consideration. But investors would do well to avoid the pitfalls inherent with competition-style investing. Here are some things to watch out to make sure you don’t fall into one of these traps.
- Monitor Your Risk When Seeking Higher Returns
- If you want higher returns, you usually have to take on a little more risk to get them. But one of the most prevalent investing concerns is that investors don’t fully understand these risks often dazzled by the potential upside and ignoring the downside when evaluating opportunities. Stay disciplined.
- Don’t Increase Your Risk Just To Make Pre-Determined Performance Goals
- It’s one of the classic mutual fund manager mistakes. They’re notorious for taking inordinate risks to attract new clients or make a certain amount of money. If a fund has a chance to make a top 10 list at the end of the year, they know that such acclaim and publicity will lead to much greater capital inflows - with higher fees and bonuses to follow. That means managers can be tempted to take bigger risks with existing investors’ money. If the risk works out, they reap some fat rewards. But if the wheels fall off, the fund will lose capital and credibility.
If you find your investment returns lagging your goal for any given month, quarter, or year, don’t fall into the trap of hiking up your risk to make up the shortfall. Doing so, just to get to an arbitrary performance mark, will more than likely put you on the fast-track to lose money, not make it.
Great trading,
D. R. Barton, Jr.
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Today’s Smart Profits Action Center
- In September 2006, one trader proved exactly why ignoring risk and the “all or nothing” investment mentality is so dangerous. He lost $4.5 billion in one week for his Amaranth hedge fund by taking huge long positions in natural gas futures contracts. Trouble was… nobody was interested in trading so far out and in such large volume - leaving the fund extremely overweight in extremely illiquid assets. The lesson here: Make sure you assess your risk and don’t invest too money much in one place.
- Warren Buffett is a master of knowing the best places to invest at the best time. And listening to proven experts like this is one of the best ways to accelerate your wealth. In a recently-published report, an elite group of the world’s best investors and money managers have revealed 31 proven “secrets of the masters,” showing you the tips and wealth-building strategies you need for success. You’ll hear from renowned experts like PIMCO bond king Bill Gross, Jeremy Grantham, Richard Russell, John Templeton and John Bogle and many more. Follow this link and find out how to book gains of 119%, 190%… all the way up to 4,001% a year.
Related Articles:
- Mutual Funds: How To Interpret The Actions of Mutual Fund Managers
- Financial Risk Management: Know Your Risk Tolerance Before You Trade
- Trading With Confidence: How You Can Develop More Confidence In Your Trades
The Chart Of The Week
Sun Microsystems (Nasdaq: SUNW) is approaching a key support level at $5. A close below this level will have dire consequences for this stock. If it doesn’t close below there, look for more choppy trading between that support level and the gap resistance at $5.60 that was established in late April. Sphere: Related Content
