Jun

11

The Investing Philosophy of Warren Buffett: Part 1

Filed Under Investing, Warren Buffett | 5 Comments


Warren Buffett, currently the world’s richest person according to Forbes Magazine, is arguably the world’s greatest investor. As I mentioned in my review of his biography, Buffett: The Making of an American Capitalist, he has achieved extraordinary rates of return with minimal risk over an investing career of over 50 years. I’m always curious at how people who are at the top of their fields do what they do, so I’ve been studying Buffett for over 10 years. In my next few posts, I will be summarizing some of the most important components of his investment philosophy.

Rule #1: Never lose money. Rule #2: Never forget Rule #1.

The most important of Buffett’s principles is the idea that you should approach investing with the mindset that you should never lose money. While avoiding all losses might not be possible, you can at least limit your losses to very small amounts. One reason that this is so important is due to the difficulty in overcoming losses. For example, if you take a 25% loss on an investment, you need to earn a 33% return just to get back to your original starting point. I don’t know about you, but I personally don’t want to create that much extra work for myself! Consequently, I set a high standard for myself before I will part with my cash. If it doesn’t look like a particular investment opportunity is safe from capital loss, I am content with leaving my money in a money market fund while I wait for a better investment opportunity to arise.

Many people also have the mistaken notion that you need to take high risk in order to achieve high returns, but low risk is not inconsistent with high returns. In fact, the same principles that reduce your risk can also help increase your returns. This requires a very different mindset from the conventional wisdom that has come to be accepted in the investing industry. Investing is one of the few areas in life where “old school” thinking is far superior to currently accepted ways of thinking. Achieving high returns and low risk simultaneously requires throwing out the flawed thinking that dominates investing today and instead embracing principles that pre-date today’s conventional wisdom.

Understand the difference between price and value.

One critical concept to understand is the difference between price and value. These terms are quite often used interchangeably, but this betrays a lack of understanding of the difference between the two terms. As Buffett wrote to his investors in his investment partnership back in 1966: “Price is what you pay. Value is what you get.” The basic concept is that an asset has an underlying value or “intrinsic value” that is separate from its price. Even if it were impossible to sell an asset, it would still be inherently valuable. For example, if you own a house, it would be valuable to you whether you could sell it or not. Similarly, a business is valuable whether you intend to sell it or not because it generates cash flows. As Buffett wrote in the Berkshire Hathaway Owner’s Manual:

“Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.”

A great example of the difference between price and value was clearly demonstrated in the “dotcom” bubble of the late 1990s and in early 2000. Rarely have stock prices been so divorced from reality as during this time period. Few people were buying Internet stocks for the long-term. Instead, people were buying these stocks in order to sell them quickly with the hope of instant riches. The underlying value of the stock wasn’t much of a consideration as long as the stock was in a hot sector. Many of these stocks simply had horrible economic prospects. Investors were not carefully weighing the expected future cash flows of each company. Even many of the entrepreneurs that were building these businesses were doing so in order to take advantage of the absurd prices by quickly selling the companies. Often they realized that the economic prospects were not nearly justified by the prices being offered in the market, so they were trying to unload the companies while “the iron was hot.”

Think like an owner.

In order to better understand the concept of intrinsic value, think of an owner of a private business. Private businesses are much more difficult to sell than businesses that are sold (or “traded”) on a stock exchange. With a private business, you don’t have thousands of people telling you how much they are willing to pay you to buy your business every second of the day. To understand what the business is worth, you have to understand the underlying cash flows. For example, suppose you have a business that currently generates about $100,000 in “free cash flow” that you can pull out of the business this year, and you expect that this cash flow will increase each year by about 5%. How much could an investor pay for such a business and earn an adequate rate of return on the investment? This is the “intrinsic value” of the business, and it has nothing to do with stock market psychology, looking at stock price charts, trying to guess what the Fed is going to do, or any number of things that stock market pundits like to talk about it.

Great investors like Warren Buffett are able to filter out the noise from the stock market and focus their attention on what’s most important – the fundamentals of the business. Focusing on the business instead of the market is the key to rational investing. Think of yourself as an old school capitalist looking to buy a business rather than looking to electronically trade some pieces of paper in the hope that someone will be willing to pay you more for it tomorrow.

To be continued…

Jun

9

Tools for Tracking Your Finances

Filed Under Personal Finance | Leave a Comment


In my Keep Score by Tracking Your Net Worth blog post, I talked about the benefits of keeping score if you want to improve in a specific area of your life. Tracking your results, especially in numerical terms, focuses your attention on the impact that your actions are having in objective terms. In the area of finances, I recommended focusing on your net worth and its components. Your net worth represents your financial position at any point in time. Just as weighing yourself regularly will tell you if your diet or exercise program is helping you lose weight, reviewing your net worth regularly will tell you if your decisions that impact your finances are making you stronger or weaker financially.

One way to track your finances that has been used successfully for many centuries is the “old school” method of using a pen or pencil and some paper. However, although this method gets the job done, most people find that this method is far too tedious. Luckily, software comes to our rescue and makes our job much simpler.

Spreadsheets

One solution is to use spreadsheets to track finances. Spreadsheets have the benefit of being extremely flexible and incredibly powerful, not to mention that there are free spreadsheet programs available. I find that spreadsheets are useful when your needs are either very simple or very complex. If your needs are very simple, then you won’t want to bother getting specialized software. If your needs are very complex, then specialized software might not have all the functionality that you need, so spreadsheets might be helpful in providing additional functionality to better satisfy your specific needs.

I have created a spreadsheet that you can use for free if you just want to keep things simple and you have at least a rudimentary understanding of spreadsheets. It’s called the Monthly Net Worth Tracker. You simply update it each month with the current values of your assets and liabilities. The instructions are included in the spreadsheet. If you don’t have Excel, the spreadsheet appears to work fine on OpenOffice.org Calc, which is part of the free office productivity suite that can be downloaded from the OpenOffice.org website.

Personal Finance Software

If you are intimidated by spreadsheets, or if you want something that is much more automated and has built-in functionality to help you track spending and easily create reports and graphs (among other functions), then you will probably be interested in using personal finance software. You might have heard of Quicken and Microsoft Money, which are the leaders in the industry. I have been using Quicken since 1995, and I’m amazed at what it can do. They keep adding features and improving the product, and the level of automation keeps getting better and better. Here are some of the things that personal finance software can do for you:

1) Download all of your account activity over the Internet. I use the Internet to download transactions for all of my financial accounts (checking, savings, investment accounts, credit cards, etc.) except for one account that doesn’t offer it. Some of the accounts can be downloaded automatically by Quicken. For other accounts, I simply go to the website for that account and click a button to download my transactions, which are automatically loaded into Quicken.

2) Automatically reconcile your accounts. Many accounts, such as checking accounts and credit card accounts, can be automatically reconciled if you download your activity over the Internet. The software will automatically match up the cleared transactions and reconcile the account for you. This is an amazing feature and a great timesaver. The software even makes manual reconciliations so much easier.

3) Easily track your spending. After you download your transactions, you assign an expense category and “accept” the transaction to be entered into the software. For transactions that are recurring, the software will remember the category you used last time, making it even easier. For example, the software will learn the name of your electric company and automatically assign it to “Utilities Expense” if that is how you track it.

4) Automatically update your portfolio values. The software can automatically download securities prices over the Internet and adjust your daily portfolio values.

5) Generate numerous pre-programmed reports and graphs. The software includes reports and graphs that tell you your net worth, income & spending, portfolio allocation, and all sorts of information, and they are easily customizable. For me, the Net Worth and Income & Expense reports are critical to my understanding of my financial situation.

6) Much, much more. Personal finance software has so many functions these days that I don’t come close to using all of them. For me, the most valuable aspect of personal finance software is the automation that it allows. I can get an update of my financial situation in a matter of minutes.

What Software Should You Choose?

If you decided that you are interested in trying personal finance software, there are three main personal finance solutions that I’m aware of (although there are certainly other lesser known solutions out there). The first two I already mentioned: Quicken and Microsoft Money, which have been around since at least the early 90s. However, there is also a relative newcomer called Mint that has been generating a lot of attention. Mint offers free online personal finance software.

From my own research, Quicken appears to get the best reviews. Microsoft Money’s reviews seem to be slightly worse, although my guess is that it would probably still do a pretty decent job. Both Quicken and Money get horrible reviews from Amazon.com (see the links to reviews below), although reviews elsewhere seem to be relatively positive. The two main complaints seem to be a requirement to buy an upgrade every few years and poor technical support. Mint’s reviews seem to be pretty positive, although the reviews suggest that Mint’s features are more limited than those of Quicken or Money.

As I mentioned earlier, I have been using Quicken since 1995, and I have been very happy with it. I have had occasional challenges in setting up accounts to automatically update, but overall the issues have been pretty minor. My guess is that most people would be pretty happy with any of the three programs. They appear to have most of the same functions. You don’t have much to lose in trying them out. Quicken offers a 60-day 100% satisfaction guaranteed return policy, Microsoft Money offers a 60-day free trial, and Mint is completely free.

At the very least, you can try one of the programs, set up your checking account in it, and play around with it for a while. It’s worth a shot. And if you like it, you can set up the rest of your accounts.

The About.com reviews

Quicken Deluxe 2008
Money Plus Deluxe 2008
Mint

The cnet reviews

Quicken Deluxe 2008
Money Plus Deluxe 2008

AOL Shopping customer reviews

Quicken Deluxe 2008
Money Plus Deluxe 2008

Amazon customer reviews

Quicken 2008 Deluxe
Money Plus Deluxe

Webware reviews

Mint review #1
Mint review #2

Jun

4

Hello world!

Filed Under Miscellaneous | Leave a Comment


Hello, this is Mark Cancellieri. I am currently in the process of transferring my website to a new host, but I should be back up and running soon!

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