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Warren Buffett's 2013 Annual Letter to Berkshire's (NYSE:BRK.A)(NYSE:BRK.B) shareholders has finally been released (March 1). Aside from walking through Berkshire's businesses (GEICO, BNSF, Iscar, MidAmerican etc.), he also allocated a large portion of his annual letter to explaining some fundamental investment principles. I will summarize what Buffett wrote and add some additional insights.

Main Lesson: Investment is Most Intelligent When It is Most Businesslike

In Chapter 20 of The Intelligent Investor, Ben Graham, Buffett's mentor and teacher, made the follow observation:

Investment is most intelligent when it is most businesslike.

Buffett also referenced the same quote in his letter. He illustrated that principle by referencing two purchases he made. One was a farm he bought in 1987 after a property bubble popped. When Buffett evaluated the prospective purchase, he did not try to predict the future price of the farm. Instead, he estimated the future earnings power of the farm by estimating expenses and production. Also, he estimated that the productivity of the farm would increase over time and crop prices would slowly increase as well.

Both predictions were proven correct, and his farm is worth 5 times more than he paid in 1987. There would be some bad years, but production and prices would gradually increase over time despite having volatile year-over-year swings. The point he wanted to make is that investors should avoid predicting future prices of the asset and instead focus on the future productivity of the assets (in terms of earnings and cash flow). Evaluate the investment from a buyer of a business, not as a buyer of a ticker symbol.

Lesson on Market Fluctuation: Take Advantage of It, Don't Try to Follow It

Buffett admits that the advantage he had with his two real estate investments he made was that there was no active quotation of his investments. However, Buffett would have liked it if there would have been a crazy neighbor down the street that could have offered him some crazy quotations. If the neighbor offered to buy his interest in the farmland at a ridiculously high price, he would have sold it and vice versa.

However, there is crazy fellow in the stock market called Mr.Market that any investor can do business with every day. Buffett advised investors to take advantage of his mis-pricings, but never behave like him. Take advantage of Mr.Market's mood swings, but don't try to follow them. When he's greedy, be fearful. When he is fearful, be greedy. It's a lesson Buffett reminds investors over and over again throughout various market cycles.

Buffett's Five Main Points on Investing:

Buffett summarized sound investing principles in 5 concise bullet points. I have paraphrased what he wrote below, along with some of my own comments:

  • You don't need to be an expert in order to achieve superior returns. However, you do need to understand your own limitations, i.e. if you are not good at stock picking, don't do it. Don't ever try to make a quick profit.
  • Focus on the productivity of the assets. For a stock, it simply means that you need to focus on the earnings and cash flows of the business. if you can't estimate the company's future earnings stream, don't invest in the stock. Why try to jump over a 7 foot bar when you find another 1 foot bar you can step over.
  • If you buy a stock because you think the price will go up, that's speculation. An even worse mistake is to buy a stock because it has gone up. Momentum investing is fun, but only if you can get out before the train wreck, which is hard to do on a consistent basis.
  • Don't worry about daily market fluctuations. There is no need to check the value of your portfolio on a daily basis. It would be silly to phone the real estate broker every day asking the price of your house. Yet, many investors check their portfolios every day.
  • Macro investing is pretty much useless for long term investing. Listening to the advice of market pundits may blur your own vision of facts that are really important. Most DIY investors are saving for retirement and have investment horizons longer than 10 years. Why worry about whether the market will drop 5%? Do you worry when the temperature drops from 80 to 76? The magnitude of change is the same (5%) in both cases, yet many people hardly notice a 5% change in temperature, but get extremely emotional about a small 5% decline in the market.

Suggestion For The Average DIY Investor:

Buffett also stated some good news for non-professional investors. Since American businesses, on aggregate, will increase in value over time, DIY investors can benefit by buying a diversified basket of American businesses (stocks) and keeping costs low. Buffett's portfolio for his wife consists of 90% in Vanguard S&P500 fund (NYSEARCA:VOO) and 10% in short term government bonds. Keeping costs low is critical to long term success. Buffett notes that many investors have poor returns because they trade too much or pay high management fees.

I would add that DIY investors would do well if they followed Buffett's advice, but also add in the dollar cost averaging approach as well. For example, you save $1100 every quarter and invest $1000 in VOO and $100 in short term government bonds (NASDAQ:VGSH).

Ben Graham also illustrated the power of the dollar cost averaging approach in The Intelligent Investor (introduction, page 2) when he backtested John J. Raskob's claim in Ladies' Home Journal:

Our calculations- based on the assumed investment in the 30 stocks making up the Dow Jones Industrial Average (DJIA) - indicates that if Raskob's prescription [putting $15 per month in the Dow] had been followed during 1929-1948, the investor's holdings at the beginning of 1949 would have been about $8,500, a far cry from the great man's $80,000. But, as an aside, we should remark that the return actually realized by the 20-year operation would have been better than 8% compounded annually and this despite the fact that the investor would have begun his purchases when the DJIA at 300 and ended with the valuation of 177

I have no doubt that there would be many more market declines in the next 20 or 30 years. However, investors should rest assured that even if you started investing at the 1929 level and experienced a bear market decline of 41% over 20-years, a dollar cost averaging strategy in low index funds can still yield a reasonable result. Mr.Raskob may have exaggerated the attractiveness of his strategy, but it is a sound one and one that the average investor should adhere to. Using the CPI on the Minneapolis Fed's website, the $15 per month suggestion in 1929 is equivalent to $210 today.

The Bottom Line:

Buffett reminds investors in his latest Annual Letter to follow sound investing principles. For active stock pickers, this means focusing on buying good businesses with solid earnings and cash flow. For passive investors, this means keeping costs low by owning an index ETF and understand your own limitation so you won't jump on the speculation train. As he stated in his 2012 letter (page 6), investing is a game that is heavily stacked in your favor if you are disciplined and focus on the long run. I'll end this article with my favorite Buffett quote that investors should remember at all times: "be fearful when others are greedy and be greedy when others are fearful."

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is for informational purposes only and does not constitute an offer to buy or sell any securities discussed in the article. Investors are recommended to conduct further due diligence before committing capital to any investment.

Source: Investing Lessons In Buffett's 2013 Annual Letter