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What Would Warren Buffett Do?

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All around you, people are investing. They speculate in tiny companies with a good story, they put their money into global businesses with well known brand names, and at social occasions, they talk about these investments -- certainly their successes, occasionally their failures.

Perhaps you've collected an assortment of random stocks and some mutual funds, too. In addition to occasional bragging rights, this gives you something to watch on your portfolio list in the papers or on a Web site. On a good day, it can give you a boost and that alone can make it worth the money you've invested. On a bad day—which can stretch into a bad week or a bad month or worse—it can become an obsession and a way to relive a failure over and over and over again.

I've been talking to investors for more than 10 years, and most of them don't even understand what game they're playing, let alone the rules of the game. In a famous book from the 1930s, entitled Where Are The Customers' Yachts?, the author, a former stock broker, observes that brokers always seem to do quite well, accumulating toys and other symbols of success, while the clients (or "customers" as they were known back then) don't seem to do nearly so well. Flash forward 70 years, and nothing has changed. Study after study demonstrates that individuals fare poorly as investors.

My guess is, you're no different. There's only one Warren Buffett. If you want to buy a share of his company, Berkshire Hathaway, it's available to you. As of this writing, it's priced at $120,000 per share. Sound like a lot? Maybe it is, maybe it isn't. I've probably given this advice to go buy Berkshire Hathaway, dozens of times. When I started, a decade and a half* ago, shares of Berkshire Hathaway went for about $9,000 a share. People said "that's expensive," back then, too. They also said, "does he still have the gift?" and "Is he going to retire?" Those were all legitimate questions back then, and they are still. I wish I knew the answers. But just as I don't know what's going on in the mind of the latest CEO who's projected to save America's economy, I also don't know what's inside Warren Buffett's head. I never have. And I never will.

I do, however, understand how to make money in the stock market. Throughout history, great investors, including Warren Buffet, have told us the secret to successful investing. Only a fraction of us have followed it. The secret is diversification. Here's what you might be thinking right now: But I do diversify already. I own 15 different tech stocks. Or, I own 10 different mutual funds. Or, I have three different financial advisors managing my money.

None of this is true diversification. Diversification is mostly science and a little bit of art. Economists have won Nobel prizes for helping us understand diversification. They speak about modern portfolio theory, efficient frontiers, and asset allocation. Diversification is complicated stuff.

What most people do is spread their money out and think they've diversified. In fact, diversification comes down to a simple premise called "non-correlating markets." Here's a simple example: You own shares in two companies. One's a sun tan lotion company and the other is an umbrella company. That's a well-executed diversification plan because you own shares in companies that do well in different weather situations. As a result, you've got a way to make money whether it rains or shines. Unfortunately, the world's a lot more complicated than that example and you can't intuitively diversify your money. It takes sophisticated models to truly diversify. But the demand for diversification has been so great from the institutional investors—such as pension funds and endowments—that a slew of powerful tools have been created to develop more accessible models. And a few pioneers, like John Bogle, founder of Vanguard and the eponymous founder of Charles Schwab, have made it their lives' work (along with their lives' fortunes) to bring these tools to you.

As complicated as it is, diversification can be had today with a single mouse click. It's simple, elegant, and there for the taking. You may have heard about index funds or "passive investing." These are related to diversification, and they are an investor's best friends. Even Warren Buffett believes in them. In fact, he recently placed a million-dollar bet that an index fund based on the S&P 500 would outperform a collection of hedge funds. Embracing diversification is at the heart of this blog. To learn more about it, check out our mission statement.

* This sentence was incorrect when first published.

Got a question? Please send it to me at investingguide@inc.com.

Last updated: Jul 2, 2008




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