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This book is dedicated to four of the most important people in my life, my grandchildren—Jonathan, Sophie, and Gracie Rosen, and Ruby Jane Morris Contents Introduction: Why I Wrote This Book 1. Want to Invest More Like Warren Buffett? Start Taking His Advice 2. Want to Invest More Like Warren Buffett? Start Thinking Like He Does 3. Should You Be an Active or a Passive Investor? 4. The Need to Plan: It Is Not Only About Investments 5. How Much Risk Should You Take? The Asset Allocation Decision 6. How to Build a Well-Designed Portfolio 7. The Care and Maintenance of Your Portfolio 8. Should You Hire a Financial Advisor? 9. Winning the Game of Life Conclusion 30 Rules of Prudent Investing Notes Sources Index Acknowledgments Introduction: Why I Wrote This Book Each of my 12 books is about what I call the “science of investing,” the evidence demonstrating the prudent investment strategy. My Only Guides You’ll Ever Need series deals with stocks, bonds, alternative investments, and the designing of the right financial plan. My Wise Investing series is a collection of stories and analogies designed to demonstrate that the winning investment strategy is a simple, elegant, and logical one. And because it is so simple, requiring little effort (though lots of discipline), it is also the winning strategy in life. What I have learned from my experiences is that not many people will devote a lot of time to learn about investing despite its importance. It is difficult to get them to read a 300-page book that cites dozens of studies. That is why I have written this book. Think, Act, and Invest Like Warren Buffett is designed to explain how adopting some basic principles can help you outperform the vast majority of investors and increase the chances of achieving your financial and life goals. Over the years, I have talked to thousands of people about investing. I have learned there are some individuals who can be successful investors on their own. If you believe you fall into that category, Chapter 8 provides five important questions for you to answer before you decide to go it alone. Many others have found great benefit in working with an advisory firm. For those who want to consider working with an advisor, Chapter 8 also provides information on how to perform thorough due diligence as you search for a fiduciary advisor who can truly add value, such as making sure your investment plan is part of an overall financial plan that addresses estate, tax, and insurance issues. 1 Want to Invest More Like Warren Buffett? Start Taking His Advice If investors were asked, “Who do you think is the greatest investor of our generation?,” an overwhelming majority would answer, “Warren Buffett.” If they were then asked, “Should you follow the advice of the person you consider the greatest investor?,” you would think that they would say, “Yes!” The sad truth is that, while Buffett is widely admired, the majority of investors not only fail to consider his advice but also tend to do exactly the opposite of what he recommends. To demonstrate the truth of this statement, we will review Buffett’s investment guidance and see if people have actually followed it. We will review his advice on three issues: 1. Whether you should invest in actively managed or passively managed mutual funds (such as index funds). 2. Whether you should listen to market forecasts. 3. Whether you should try to time the market. Actively managed funds attempt to uncover and exploit securities the market has “mispriced,” buying those they believe are undervalued and avoiding those they believe are overvalued. Actively managed funds may also attempt to time investment decisions to be more heavily invested when the market is rising and less so when the market is falling. In contrast, passively managed funds are basically buy-and-hold vehicles that eschew stock picking and market timing, believing the costs outweigh the benefits. Active investors also look to “experts” for an investing edge, while passive investors ignore such advice. Before reviewing Buffett’s advice, it is important to note that he knows that you cannot invest exactly like he does. You cannot buy entire companies and incorporate them into Berkshire Hathaway, nor can you negotiate special deals during crises, when companies such as Goldman Sachs are willing to pay “top dollar” to have Warren Buffett invest. However, you can follow his guidance about the right investment strategy. As you read Buffett’s advice, ask yourself if you have been practicing what he preaches. Let’s begin with Buffett’s advice on which type of funds you should invest in. ACTIVE VERSUS PASSIVE INVESTING The following are some of the Oracle of Omaha’s words of advice on this important decision: • “By periodically investing in an index fund, the know-nothing investor can actually outperform most investment professionals.”1 • “Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat [emphasis mine] the net results (after fees and expenses) delivered by the great majority of investment professionals. Seriously, costs matter.”2 • “Over the 35 years, American business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns: all they had to do was piggyback Corporate America in a diversified, low-expense way. An index fund that they never touched would have done the job. Instead many investors have had experiences ranging from mediocre to disastrous.”3 • “So many investors, brokers and money managers hate to admit it, but the best place for the average retail investor to put his or her money is in index funds.”4 What is difficult for many investors to understand is that indexing works because not making investment decisions (trying to pick stocks or mutual funds or trying to time the market) produces better results than making them. Of course, no one on Wall Street would ever admit that. Remember, Wall Street benefits from the higher fees and greater commissions generated by active strategies. It needs you to play the game of active management because that is its winning strategy. We now turn to Buffett’s advice on whether you should pay attention to economic and market forecasts. THE VALUE OF FORECASTS The following is Buffett’s advice on whether you should be paying attention to the latest forecasts from so-called economic and market experts: • “We have long felt that the only value of stock forecasters is to make fortune-tellers look good. Even now, Charlie [Munger] and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children.”5 • “A prediction about the direction of the stock market tells you nothing about where stocks are headed, but a whole lot about the person doing the predicting.”6 Most investors find it hard to believe that their life would be better without so much information and that ignoring the investment noise would improve their performance. This leads to the condition I call “CNBC-itis,” the need to “tune in.” While investors believe they are tuning into valuable information, what they are generally hearing is nothing more than what Jane Bryant Quinn calls “investment porn,” and what she feels are “shameless stories about performance that tickle our prurient financial interest.”7 Instead of tuning in, you should be tuning out. Buffett implores investors to ignore forecasts because they tell you nothing about where the market is headed. Research also proves this. The following is a brief summary of that research: • Economists’ forecasting skill has been about as good as guessing. Even those who directly or indirectly run the economy—such as the Federal Reserve, the Council of Economic Advisors and the Congressional Budget Office—have forecasting records worse than pure chance. Even worse, just when you need the forecasts to be most accurate, they have been the most wrong. Economists have not predicted the turning points.8 • There have been no economic forecasters who consistently lead the pack in forecasting accuracy.9 • Increased sophistication in forecasting has not improved the accuracy of forecasts.10 • The only thing that relates to forecasting accuracy has been fame, and the relationship has been negative. The more famous the forecaster, the more inaccurate the forecasts.11 Why do investors pay attention to forecasts, ignoring the evidence and Buffett’s sage advice? My experience has convinced me that this irrational behavior is caused by an all-too-human need to believe that there is someone who can protect us from bad things, such as bear markets. Unfortunately, there is only one “person” who knows where the market is going. If we ask Him, we won’t get an answer, at least not in this lifetime. And in the next one, it won’t matter. This is why whenever I am asked about my forecast for the economy or the market, my answer is always the same: “My crystal ball is always cloudy.” What we have learned is that we are no closer to being able to predict the market despite all the innovations in information technology and decades of academic research. The next time you are tempted to act on some guru’s latest forecast, ask yourself the following questions: • Is Warren Buffett acting on this expert’s opinion? • If he isn’t, should I be doing so? • What do I know about the value of this forecast that Buffett (and the market in general) doesn’t? Author Carl Richards, in his book The Behavior Gap, recommends asking three questions before you act on someone’s advice or forecast:12 • If I make this change and I am right, what impact will it have on my life? • What impact will it have if I am wrong? • Have I been wrong before? MARKET TIMING The following are some of Buffett’s admonitions to those who are tempted to time the market: • “Our favorite holding period is forever.”13 • “Our stay-put behavior reflects our view that the stock market serves as a relocation center at which money is moved from the active to the patient.”14 • “Success in investing doesn’t correlate with IQ. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people in trouble investing.”15 • “Inactivity strikes us as intelligent behavior.”16 It can be hard to hear that the best course of action during tough market times is to stay the course. Keeping your head while everyone else around you is losing theirs is difficult. It can be even harder to hear that message repeated while things go from bad to worse. However, the message to stay the course is worth repeating because it is the best advice. Because there is no evidence that there are