Warren Buffett provided some words of wisdom in his recently released annual letters to the shareholders of Berkshire Hathaway.
Buffett’s comments touched on the four disciplines leading to success in the insurance business and could be applied equally as well to investments.
Our observation is with most endeavors there is a formula for success. Certain things are fundamental to obtaining success and certain things often lead to failure.
For profitable investing, we recommend all investors understand the basics of investing and then have the discipline to invest accordingly.
Here are four things to consider:
- One – Understand all exposures that might cause a policy to incur losses.
The risk of loss to a long-term investor is the chance you will lose all your money.
That is a possibility. It has happened to many people before and it will happen to many people again.
You could purchase a stock or bond and the value of that investment could decline to zero. Remember Nortel?
The best protection is to own a diversified portfolio consisting of many different asset classes. You will still experience volatility, however, it is unlikely that a diversified portfolio of hundreds, or thousands, of different investments will lose all of its value.
- Two – Conservatively assess the likelihood of any exposure actually causing a loss and the probable cost if it does.
In this case, you can let history be your guide. Review the past performance of asset classes to give you some understanding of the degree of volatility that has occurred.
Studying past volatility of an asset class, for example Canadian stocks or U.S. stocks, gives you some sense of what you might anticipate in the future.
Set a premium
- Three – Set a premium that, on average, will deliver a profit after both prospective loss costs and operating expenses are covered.
The key word is profit. If you have a diversified portfolio the probability of a profit is fairly high, if you continue to hold your investments for the long-term.
There is risk to investing in just one stock or a concentrated holdings of a few stocks because if any one security declines significantly in value because of a business failure then you might not have the ability to recover your investment.
Diversification is key. Follow the principle of safety in numbers and avoid the temptation to invest in just a few securities.
Be willing to walk away
- Four – Be willing to walk away if the appropriate premium can’t be obtained.
There is no such thing as an investment that is too good to be true. Sometimes specific investments are oversold because of their “fantastic” upside.
For example a few years ago when the price of oil was several times higher than it is today some people might have been tempted to over invest in an oil-based security.
That can be a good lesson to the perils of not diversifying. Investors cannot afford to take excess risk and often the best solution is to not make an investment in the first place.
Follow these four pieces of advice on investing and you are more likely to have positive results.