Warren Buffett’s 9 Key Investing Rules
Warren Buffett is a successful long-term value investor with timeless wisdom to share. So how did he make his billions by investing? Here are nine of Warren Buffett’s essential investing rules to follow during your investment journey.
- Don’t lose money.
- Invest by facts, not emotions.
- Buy wonderful businesses, not ‘cigar butts.’
- Only invest in companies you understand.
- Stay inside your circle of competence.
- Commit to stocks for the long term.
- Strategically diversify your investments.
- Evaluate a company’s intrinsic value.
- Avoid certain investments.
1. Don’t lose money.
“Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.” – Warren Buffett
Warren Buffett has lost money in his lifetime. In fact, in the 2008 financial crisis, Buffett lost about $23 billion.
So why the advice to never lose money? Buffett wants you to be a careful investor and view this rule as your #1 priority. For example, avoid gambling in the stock market (e.g., day trading). Research before you invest in any company. Avoid weak companies. Instead, find well-established companies with low debt and very high profits.
Some strong value companies include
- JPMorgan Chase
- Bank of America Corporation
- Berkshire Hathaway
- Procter & Gamble
- Johnson & Johnson
Buffett practices what he preaches. Before ever investing in a company, he reads all of its annual reports, going back as far as he can. He thoroughly investigates the company’s strategy, management, progression, etc. Once he purchases shares or the entire company, he holds his investments for the long term.
Another tip? Investing doesn’t have to be complicated to make money.
According to Buffett about financial advisors, “It’s amazing how hard people make what is a simple game. But of course, if they told everybody what a simple game it was, 90% of the income of the people that were speaking would disappear.”
You also don’t have to select individual companies. You can simply invest in low-cost index funds (i.e., a fund that holds every stock in an index) such as the S&P 500 which includes companies like Amazon and Coca-Cola. This strategy means your investments are automatically diversified and you can make money over the long term.
If you’re wondering, Buffett keeps a lot more money than he loses. As of Jan. 11, 2020, Buffett’s net worth was $87.9 billion. He’s the seventh richest person in the world.
2. Invest by facts, not emotions.
“Be fearful when others are greedy, and be greedy when others are fearful.” – Warren Buffett
Emotions are one of the deadliest enemies of investing. Too often, investors get scared by market swings. They then panic buy and sell.
While Buffett recognizes that emotions are part of human nature, he recommends not being controlled by them.
One way to avoid emotional investing is to limit your news consumption. News outlets want an emotional response. Bad news sells, after all. Most of it, though, is just noise.
According to Buffett, “Owners of stocks, however, too often let the capricious and often irrational behavior of their fellow owners cause them to behave irrationally as well.”
He continues, “Because there is so much chatter about markets, the economy, interest rates, price behavior of stocks, etc., some investors believe it is important to listen to pundits – and, worse yet, important to consider acting upon their comments.”
Stick to your investment strategy rather than being carried away by every financial news story. For example, should you sell your position in Target because the stock dropped 15% since purchasing? Or should you panic because Johnson & Johnson missed their quarterly earnings estimate by a small percent?
No, probably not. The fundamentals of the company haven’t changed. They are experiencing temporary setbacks that won’t affect their long-term earning power.
Instead, take advantage while other investors are panic buying and selling. If a quality company’s share prices have decreased because of market news, consider buying more of the company’s stock.
3. Buy wonderful businesses, not ‘cigar butts.’
“It’s far better to buy a wonderful company at a fair price, than a fair company at a wonderful price.” – Warren Buffett
“Cigar butts” are companies selling at a wonderful price that produce a one-time profit. But wonderful businesses will keep producing profits over time. In short, Buffett doesn’t invest in companies just because they are on sale.
Buffett’s strategy has actually changed over time. He began his investing career investing in cigar butts, just like his mentor Benjamin Graham.
The “cigar-butt” style of investing means picking up discarded business cigar butts laying on the side of the street. These butts have one good puff of value left in them. You sell them at a big discount to their book value.
Buffett moved on from this strategy when he decided it wasn’t worth the trouble. Basically, businesses that sell at a major discount typically have many problems. It’s not the wisest allocation of your money over the long term.
“First, the original “bargain” price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces – never is there just one cockroach in the kitchen,” Buffett says. “Second, any initial advantage you secure will be quickly eroded by the low return that the business earns.”
He switched to buying only the best companies selling at less than their intrinsic value.
A good example of investing in wonderful businesses is Buffett’s investment in Coca-Cola (fun fact: Buffett drinks five cans of Coke a day). In 1987, he invested more than $1B in the company. Now, the dividends from this investment earn more than half the original investment amount yearly.
4. Only invest in companies you understand.
“Never invest in a business you cannot understand.” – Warren Buffett
Hot stocks and investments like cryptocurrencies might seem like good investments. But do you actually understand how they work? If not, you could be swimming in dangerous waters.
Buffett doesn’t understand or appreciate technology companies. He avoids investing in them altogether. He might have missed out on companies like Google and Amazon, but he has also avoided risky investments.
This might seem like common sense, but too many investors blindly invest because everyone else is doing it.
Here’s a good example: thousands of investors bought mortgage-backed securities during the housing bubble of 2008. These investors were unaware that many of these securities were made up of low-quality loans.
Don’t invest in companies that require a high level of expertise (e.g., biotech companies). Make sure you understand the company, its stock, business model, etc. Buffett has three boxes for investment ideas:
- Too Hard
Buffett moves on to another investment opportunity if a company’s business or product is too difficult to understand, filing it in the “too hard” category.
“Warren doesn’t outperform other investors because he computes odds better. That’s not it at all,” says Bill Gates. “Warren never makes an investment where the difference between doing it and not doing it relies on the second digit of computation. He doesn’t invest—take a swing of the bat—unless the opportunity appears unbelievably good.”
5. Stay inside your circle of competence.
“Know your circle of competence, and stick within it. The size of that circle is not very important; knowing its boundaries, however, is vital.” – Warren Buffett
Similar to Rule #4, Buffett advises operating with your circle of competence. Here’s a visual of the concept:
In the black circle are your skills and knowledge from your career and life overall. In this circle, you’re the expert. The polka dot circle includes the things you only partially understand or what you don’t understand at all.
With investing, honestly define what you know better than other people such as through study or work. Stick to those areas.
According to Buffett, “What an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected”: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence.”
Maybe you’re an accountant. Financial companies would fall within your circle of competence. Or perhaps you’ve worked for a big-box retailer for years. Target could be a good value company for you.
You can expand your circle of competence slowly over time. But overall, be careful not to invest in things that don’t fall within your expertise.
6. Commit to stocks for the long term.
“If you aren’t willing to own a stock for 10 years, don’t even think about owning for 10 minutes.” – Warren Buffett
Many investors treat investing like a short-term game, buying and selling stocks every day, week, month, or year. But long-term investing generates better results.
According to global stock market data between January 1971 and December 2021, investing for any one year would have generated a positive return 72.7% of the time, while investing for ten years increased your chances to 94.15%
Although he does sell some stocks in the short term, Buffett typically holds investments for at least five years. Some stocks he’s held for 30+ years!
He doesn’t purchase stocks because he believes prices are going up in the short term. He purchases stocks because he’s convinced the companies are solid investments for the long-term that will generate revenue. Here are a few stocks he’s held for a while:
- Coca-Cola: 34 years
- Wells Fargo: 33 years
- Costco Wholesale: 22 years
- Johnson & Johnson: 16 years
- U.S. Bancorp: 16 years
Another example of a long-term investment for Buffett is Apple. Buffett began buying Apple stocks in 2016. He acquired 887 million Apple shares between 2016-2018. He now owns over $160 billion in the company and it makes up over 40% of his equity portfolio. Buffett earns $775 million from Apple in average annual dividends!
Though normally avoiding tech stocks, Buffett invested in the company because he believes in Apple’s strong fundamentals, not its short-term financial results.
Hint: You can also invest in index funds such as an S&P 500 index fund which holds 500 different companies. This way, you can invest in many different companies at once for the long term. Make regular contributions per month so your money grows over time.
7. Strategically diversify your investments.
“Diversification is a protection against ignorance. [It] makes very little sense for those who know what they’re doing.” – Warren Buffett
Diversification is the act of spreading out your money into different investments such as stocks, bonds, cash, and alternatives. It’s also investing in different industries, companies, etc. Diversification is often the battle cry of investors. But according to Buffett, it should be done very strategically.
Most people don’t have time to consistently keep up with dozens of companies in a portfolio spread over different industries and asset classes. You don’t need to spread your investments too thin. Instead, purchase a few stocks in different industries based on extensive research.
According to Benjamin Graham, Buffett’s mentor, “The determining trait of the enterprising investor is his willingness to devote time and care to the selection of securities that are both sound and more attractive than the average.”
He continues, “Over many decades, an enterprising investor of this sort could expect a worthwhile reward for his extra skill and effort in the form of a better average return than that realized by the passive investor.”
The takeaway? The average investor should still diversify. However, don’t get carried away. “I would say for anyone…who really knows the businesses they have gone into, six [stocks] is plenty,” Buffett says. “Very few people have gotten rich on their seventh-best idea.”
Or you can simply invest in an index fund that is already diversified if you don’t have as much to devote to individual company research.
8. Evaluate a company’s intrinsic value.
“Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses.” – Warren Buffett
Before investing in a company, you should thoroughly understand its intrinsic value and underlying fundamentals. Intrinsic value is what a company is actually worth, not what the market says it’s worth.
The price of an investment may go up and down, depending on the market, but the value of the company always stays the same. Knowing a company’s intrinsic value helps you invest in high-quality companies at bargain prices. As Buffett says, “Price is what you pay. Value is what you get.”
There are several ways to calculate intrinsic value. Below are two common ones: the P/E Multiple Model and the DCF Model. Combine results from different methods to get a value range. Focus on conservative estimates.
- P/E Multiple Model: Price-to-earnings or P/E multiple is a method that helps you calculate intrinsic value through a five-year price target. Here’s the formula: Intrinsic value = Earnings per share (EPS) x P/E ratio x (1 + r)^5.
- Discounted Cash Flow Model. The discounted cash flow (DCF) model estimates value based on expected future cash flows. It determines the value of a company today by projecting how much money it will create in the future.
Hint: Intrinsic value is only part of the puzzle with value investing. A full fundamental analysis is needed to ensure that you’re investing in quality companies. Here’s how to complete a full fundamental analysis and analyze a company’s fundamentals.
9. Avoid certain investments.
“I don’t know when to buy stocks, but I know whether to buy stocks.” – Warren Buffett
Just because an investment looks shiny and sexy doesn’t mean it’s a good investment, even if other investors flock to it.
Buffett avoids four types of investments because they are risky, difficult to understand, or don’t produce income:
Buffett has referred to this cryptocurrency as “probably rat poison squared.” “It’s a gambling device…there’s been a lot of frauds connected with it,” according to Buffett.
“There’s been disappearances, so there’s a lot lost on it. Bitcoin hasn’t produced anything,” says Buffett. “It doesn’t do anything. It just sits there. It’s like a seashell or something, and that is not an investment to me.”
2. TECH STARTUPS
Since Buffett doesn’t understand tech startups, he avoids investing in them. He does invest in companies like Apple and Amazon now but didn’t back in the early days of the companies because he didn’t understand their business models.
Buffett calls gold an “unproductive” asset because it doesn’t generate earnings or dividends.
In his 2011 letter to shareholders, Buffett said, “Owners are not inspired by what the asset itself can produce — it will remain lifeless forever — but rather by the belief that others will desire it even more avidly in the future.” As such, Buffett doesn’t invest in this precious metal.
He has, however, invested almost $1 billion in silver as it has many industrial and medical uses.
4. TREASURY BONDS
Buffett believes treasury bonds are a terrible investment. Why? The income from a 10-year U.S. Treasury bond fell 94% from a 15.8% yield in September 1981 to 0.93% at the end of 2020.
Buffett says, “If I had a choice today for a 10-year purchase of a 10-year bond at whatever it is…or buying the S&P 500 and holding it for 10 years, I’d buy the S&P.”
Revisit Rule #4: Only invest in companies you understand. Also carefully analyze the company’s intrinsic value and fundamentals.
Follow these Warren Buffet investing rules
A final tip from the Oracle of Omaha? “The best investment you can make is an investment in yourself,” Warren Buffett says. “The more you learn, the more you’ll earn.” Check out books, articles (like this one!), and videos that help you become a better value investor.
An online course is also an excellent resource. Sign up for the Value Investing Bootcamp: How to Invest Wisely on Udemy. This course helps you learn how to value invest, step-by-step. Check out the course here.