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20 Warren Buffett rules for investing
Warren Buffett has one of the best and longest investing track records ever. Fortunately, over the years, he has been happy to share many pearls of wisdom that help explain his success. Here are 20 of the most important.
Big ideas
- Warren Buffett is one of the best investors of all time, making him somebody every new investor should want to listen to and emulate.
- Buffett's rules for investing are straightforward in theory, but most people need help to apply them - emotional investing still reigns supreme.
- These investing rules remain powerful despite changing market conditions. They contain timeless wisdom and common sense without complex jargon.
QUOTE
“What the wise do in the beginning, fools do in the end.”
Warren Buffett runs a portfolio valued at $321 billion. He was mentored by Benjamin Graham, also recognised as one of the world's top investors. In short, he’s a man you want to listen to if you are an investor.
Since becoming CEO of Berkshire Hathaway in 1965, the “Oracle of Omaha” has overseen a 19.8% average annualised return on the company's Class A shares, currently valued at $455,000 each (March 2023). This percentage is double the value of the broad S&P 500 index, including dividend returns.
The legendary investor is known for long-term investments, dividend stocks, and cyclical industries.
Since becoming CEO of Berkshire Hathaway in 1965, the “Oracle of Omaha” has overseen a 19.8% average annualised return on the company's Class A shares, currently valued at $455,000 each (March 2023). This percentage is double the value of the broad S&P 500 index, including dividend returns.
The legendary investor is known for long-term investments, dividend stocks, and cyclical industries.
Source: AmazonThe most detailed analysis of Warren Buffetts’ Rules for investing is in the book “The New Buffettology” by his daughter Mary Buffett. His own book, “The Snowball”, also offers timeless investment advice.
Rule 1 - Don’t lose money
Rule one is self-explanatory. Buffett is a pretty risk-averse investor, which might seem a strange thing to say about the world’s greatest financier. But portfolio protection is the first step towards wealth.
Rule 2 - Don’t forget rule 1
Rule 2 simply states not to forget rule 1. He also explains how to do this - by investing in great companies, preferably when they are trading at a steep discount. Buffett cautions never to take unnecessary risks with your capital.
Rule 3 - Always have a margin of safety
This is the difference between the fair value of a company and the market value. The lower the market value relative to the fair value, the greater the margin of safety. The rule stipulates that the less you understand about the business, the larger your margin of safety needs to be if you plan to invest in it.
Rule 4 - Find companies with good financials
The stock price can be a bit slow in reflecting company fundamentals, so it’s possible to find companies that are undervalued based on financial statements such as the balance sheet, cash flow statement, and profit and loss statement.
Microsoft income statement
Annual profits and total sales are vital metrics. Still, it’s possible to find suitable investments that are not immediately obvious from the level of profit and loss. It all depends on what the market price happens to be.
Rule 5 - Find companies with good earnings
Buffett looks for companies with a strong history of earnings in the 5 to 10-year range. He is not concerned with quarterly earnings because he believes this short-term outlook is a bad attitude. A company with small profits and small earnings that is only two years old will not make it into Buffett's portfolio.
Rule 6 - Look for consistently high return on equity
Warren Buffett focuses on the return on equity (ROE) more than the earnings per share (EPS). This shows a focus on increasing business value instead of the speed of earnings growth.
Rule 7 - Return on invested capital (ROIC)
The return on invested capital (ROIC) is an important metric for quickly gauging how well a company generates returns, proportional to its investment.
FORMULA
ROIC = Net Operating Profit after Taxes / (Total Equity + Long-term Debt and Capital Lease Obligation + Short-term Debt and Capital Lease Obligation).
Rule 8 - Is the company conservatively financed?
Buffett favours companies that have large capital reserves and little long-term debt. Berkshire Hathaway sits on capital reserves of $472 Billion, as of Q4 2022. However, he advises focusing on the solvency ratio instead of the debt-to-equity ratio. A solvency ratio above 20% is considered good.
Rule 9 - Does the company earn more money than bonds?
A company that does not make a profit per share higher than the return for fixed-income assets (such as bonds) should be excluded from any planned investments. If you can obtain this rate of return with far less volatility when using a bond, there is little point in taking on the added risk.
Rule 10 - Does the company have an identifiable durable competitive advantage?
Buffett likes to understand what sets the businesses he invests in apart. Having a competitive advantage in its industry, for a period of 10 years or more demonstrates its durability. This is particularly relevant to technology stocks, which can be rendered obsolete if a rival company comes along with a superior product.
Companies in industries with high barriers to entry are often a good buy, or ones with a stranglehold on the market, such as Gillette or Mcdonald's. No rival company is likely to take over from them overnight.
Companies in industries with high barriers to entry are often a good buy, or ones with a stranglehold on the market, such as Gillette or Mcdonald's. No rival company is likely to take over from them overnight.
Rule 11 - Do you understand how the product works?
You must understand how the business functions to ensure you evaluate the associated risks and rewards correctly. Buffett only invests in a company that he understands.
Rule 12 -Avoid companies that might be obsolete in 20 years
Stronger rivals will ultimately take over mediocre companies over longer periods. The market tends to consolidate towards larger mega-corporations. In practice, however, this can be a tough rule to master or even comprehend, as it’s hard to predict the future.
QUOTE
“If a company does well, the stock usually follows.”
Rule 13 - Does the company allocate capital completely in its realm of expertise?
Certain companies can expand into markets they do not understand, which goes against Buffett’s rule 11. This is sometimes referred to as “diworsification”, where diversification makes the company more vulnerable by straying away from its expertise. Buffett believes that diversification is only for market newcomers.
Rule 14 - Is the company free to raise prices with inflation?
If a company is in a competitive market and cannot raise its prices without losing customers, it may be a stock to avoid. If a business cannot raise its selling prices with inflation, you may need a more significant safety margin before investment.
Rule 15 - Are large capital expenditures ahead?
Sometimes, a company balance sheet might look impressive. But you could be looking at it before it makes a serious investment in expensive machinery, which can impact cash flow and debt.
Rule 16 - Buy at the right time
It’s entirely possible to purchase an excellent company at the worst possible time. The stock market tends to move in unison a lot of the time so that you could be buying before a market crash. The stock might be priced very high for various reasons that do not reflect fair value. So always look to enter nearer to the lows than to the highs.
When a company buys back its shares, it can be a sign that the management believes in the company and must also believe that the stock is undervalued.
Rule 18 - Buy simple businesses
One reason for Warren Buffett’s rule 18 is that enterprises will change management over time and often into the hands of people less competent and with less experience. But simple businesses are harder to mess up.
Rule 19 - Be a long term investor
Long term investing is the core ethos of Buffett’s investment principles. The longer you hold onto good stocks, the better your returns will be. This removes the problems of short-term volatility that cause many investors to buy at a high and sell at a low.
QUOTE
“Time is the friend of the wonderful company, the enemy of the mediocre.”
Rule 20 - The best time to sell is never
Buffett would prefer not to sell his stock. He just accumulates more, earning capital gains and dividends along the way. With good stocks, the longer you hold them, the more they will be valued. Most of the time, this will not be possible because it is a short list of companies that consistently perform over the long term.
Recap
Buffett’s investment principles are elementary and straightforward to follow. The difficulty lies in maintaining a long time horizon. On average, the market wins over time yet many investors still lose. This comes down to emotional investing and a lack of guiding investment principles to follow.
By simply investing in a low-cost ETF and leaving it be, as advised by Warren Buffett, most investors would profit over the long term. For increased profits, investors can look into company fundamentals and select stocks on quality criteria, adding them to their diversified portfolio.
This strategy might not make you as rich as Buffett. But it is possible to reach your financial goals provided you stick to fundamentals and have the patience to wait out the market instead of timing it.
By simply investing in a low-cost ETF and leaving it be, as advised by Warren Buffett, most investors would profit over the long term. For increased profits, investors can look into company fundamentals and select stocks on quality criteria, adding them to their diversified portfolio.
This strategy might not make you as rich as Buffett. But it is possible to reach your financial goals provided you stick to fundamentals and have the patience to wait out the market instead of timing it.
FAQ
Q: What is Buffett's 90/10 rule?
The rule suggests that an individual should invest 90% of their money in low-cost stock index funds or exchange-traded funds (ETFs) that track broad market indexes such as the S&P 500 and the remaining 10% of their portfolio in short-term government bonds or cash reserves.
Buffett believes that most investors would be better off investing in index funds rather than trying to beat the market through individual stock selection. By investing in low-cost index funds, investors can achieve a diversified portfolio with low fees and low turnover, leading to greater returns than actively managed portfolios over time.
Buffett believes that most investors would be better off investing in index funds rather than trying to beat the market through individual stock selection. By investing in low-cost index funds, investors can achieve a diversified portfolio with low fees and low turnover, leading to greater returns than actively managed portfolios over time.
Q: What is Warren Buffett's 5/25 rule?
Buffett's 5/25 rule is a personal productivity principle that Warren Buffett uses to help people prioritise their goals and focus on what is most important to them. The rule suggests that individuals should write down their top 25 goals or aspirations and then choose the top 5 most important to them.
Once you identify your top 5 goals, you should focus all your energy and attention on achieving those goals while avoiding distractions and saying "no" to other opportunities that may arise. The remaining 20 goals on the list are considered secondary and should only be pursued once the top 5 have been accomplished.
Buffett believes that the key to success is focusing on a few important goals, rather than spreading oneself too thin by pursuing too many goals at once. By using the 5/25 rule, individuals can prioritise their goals and create a clear roadmap for achieving them, which can help them stay focused, motivated, and productive over the long term.
Once you identify your top 5 goals, you should focus all your energy and attention on achieving those goals while avoiding distractions and saying "no" to other opportunities that may arise. The remaining 20 goals on the list are considered secondary and should only be pursued once the top 5 have been accomplished.
Buffett believes that the key to success is focusing on a few important goals, rather than spreading oneself too thin by pursuing too many goals at once. By using the 5/25 rule, individuals can prioritise their goals and create a clear roadmap for achieving them, which can help them stay focused, motivated, and productive over the long term.
Q: What is Warren Buffett's average rate of return?
The total return of Berkshire Hathaway Class A shares from 1965 to 2020 was a staggering 2,810,500% or a compounded annual gain of 20.8%.
Q: What is the 10 year rule on investing?
The rule is based on the following quote from Warren Buffett. "If you aren't willing to own a stock for 10 years, don't even think about owning it for 10 minutes."
By aiming to hold an investment for at least ten years, an investor makes sure to invest in only the best businesses. Additionally, the market can be highly volatile in the short term, leaving good businesses undervalued, but over the long term, they should rise in value.
By aiming to hold an investment for at least ten years, an investor makes sure to invest in only the best businesses. Additionally, the market can be highly volatile in the short term, leaving good businesses undervalued, but over the long term, they should rise in value.
Q: What is the 10% rule in stocks?
The 10% rule in stocks refers to a common principle of risk management in stock investing. The rule suggests that an investor should limit their exposure to any individual stock to no more than 10% of their total portfolio.
By limiting exposure to any single stock to no more than 10%, investors can help manage the risks associated with stock market volatility and reduce the potential impact of any one stock on their overall portfolio. Diversification across multiple stocks and other asset classes can also help spread risk and improve overall returns.
By limiting exposure to any single stock to no more than 10%, investors can help manage the risks associated with stock market volatility and reduce the potential impact of any one stock on their overall portfolio. Diversification across multiple stocks and other asset classes can also help spread risk and improve overall returns.
Q: What is the rule of 20 in stocks?
The Rule of 20 is a simple valuation rule used in the stock market to determine whether the overall stock market is undervalued or overvalued. The rule suggests that the fair value of the stock market is equal to 20 minus the inflation rate plus the earnings yield of the market (i.e., the inverse of the price-to-earnings ratio, or P/E ratio).
In other words, if the sum of the earnings yield and inflation rate is less than 20, the stock market is considered undervalued, while if the sum is greater than 20, the stock market is considered overvalued. The rule is based on the idea that stock prices should reflect the underlying earnings potential of companies and that this potential should be adjusted for the impact of inflation on the value of money over time.
In other words, if the sum of the earnings yield and inflation rate is less than 20, the stock market is considered undervalued, while if the sum is greater than 20, the stock market is considered overvalued. The rule is based on the idea that stock prices should reflect the underlying earnings potential of companies and that this potential should be adjusted for the impact of inflation on the value of money over time.
