By investing in shares, I hope to build my wealth over the course of time. One man who has done that stunningly well already is billionaire Warren Buffett.
That is why I am using some simple elements of the Buffett approach to investing as I aim to get rich myself.
Stick to what you know
Buffett uses a concept when investing that will be familiar to readers of Stephen Covey’s book “The 7 Habits of Highly Effective People”: the circle of competence.
Sticking to what one knows when investing makes it easier to assess how attractive an opportunity really is. Buffett thinks it does not matter how large one’s circle of competence is — the key thing is knowing it and staying inside it.
Always consider valuation
Can a company with a brilliant business model that is highly profitable be a terrible investment? The answer, perhaps surprisingly, is a resounding yes.
That is because every firm, no matter how good it is, ultimately has a fair valuation. Paying more than that is a form of overpaying. Consistently overpaying for assets is not a hallmark of successful investors.
Buffett walks away from lots of share investment purchase opportunities. Sometimes it is because he does not think the company in question is great. But sometimes he reckons the company is great, but the price simply is not attractive enough.
Build in a margin of safety
To value shares, Buffett is basically using a form of the discounted cash flow model.
But to use that, one needs to make certain assumptions. Imagine I try to assess the future cash flows of BP, for example. I would need to estimate its production volumes, costs, and also the selling price of oil far into the future. Clearly it would be hard for such an estimate to be highly accurate.
That explains why Warren Buffett always builds in a margin of safety when investing. He does not invest in situations where he can profit only if everything goes according to plan. Instead, he tries to invest in shares that can be profitable for him even if his estimates of what happens in future turn out to be a little optimistic.
Warren Buffett and diversification
When I look at Buffett’s current portfolio, I am surprised by his holding in Apple.
The investment case is classic Buffett: Apple’s brand, user base, and technology give it a large “moat”, or competitive advantage. What surprises me is how large a percentage of Buffett’s overall portfolio Apple now represents.
That could be a mistake, as even the best companies can run into unexpected difficulties. In general, though, Buffett keeps his portfolio well diversified. I think that is a prudent risk management principle for investors at all levels.
Invest for the long term
Making smart choices and diversifying my portfolio is a great start to building wealth — but it is only that. Truly great companies should hopefully increase in value over time.
So, like Warren Buffett, I always invest for the long term.