There were two big moments in my life that got me hooked on investing.
The first was when I was a teenager and was introduced to the miraculous power of compound interest. It is a great gift to find the power of compounding at a young age so that you can let its power go to work for a decade or two longer than most people. The moment after I discovered the power of compounding I immediately started looking for ways to make it work for me. That search led me to a source of information that was my second big moment.
That second big moment was when I stumbled onto the Berkshire Hathaway (BRK.A) annual letters to shareholders written by Warren Buffett. I am absolutely certain that I have learned more about investing from reading those shareholder letters than I have learned from every other source combined. Those letters gradually shaped what has become my investment approach.
That approach relies on five main ideas that I took from Buffett:
1) Rule number one in investing is don't lose money. Rule number two is don't forget rule number one. If you think an investment could permanently lose some of your precious capital then take a pass. Another less risky investment opportunity will come along.
2) Know where the boundaries of your circle of competence are. If you don't fully understand something, don't invest in it. This requires being extremely honest with yourself. I know I'm not a genius, so I don't try and invest like one.
3) There are no called strikes in investing. Just do nothing until an opportunity comes along that has you trembling with greed.
4) The stock market is not there to instruct you, it is there to serve you. If you make an investment and it drops 50% on paper, don't panic. The stock market is not always rational; if the company has not been impaired in any way, then there is no harm done.
5) There is no need to over-diversify your portfolio. The risk involved in buying a security is determined by how well you understand it. It is less risky to own ten stocks that you know extremely well and have purchased at an attractive valuation than it is to own 25 stocks that you have spent little time learning. A concentrated portfolio can actually be a less risky portfolio.
Carefully adhering to numbers one through four above is how I try and weed much of the risk out of my portfolio. And by sticking to the ideas in numbers one through four, it allows me to employ number five, which is a concentrated portfolio. I think that a concentrated portfolio is the best way to compound money over the medium to long term.
And so does Buffett. Despite the fact that Buffett's equity portfolio inside Berkshire Hathaway now exceeds $75 billion, the level of concentration inside of it is still quite amazing. Here are Berkshire's ten largest positions (excluding Munich Re), at year end December 31, 2011, as listed in the recent letter to shareholders:
Johnson & Johnson
That is some pretty heavy concentration. Almost 80% of the Berkshire equity portfolio is in just ten companies. The top 3 positions make up 47% of the portfolio. The top 5 positions make up 63% of the portfolio.
And within this portfolio, I think investors may want to be paying attention to the amount of money that Buffett has invested in Wells Fargo and IBM. The amount invested in IBM and Wells Fargo combined totals almost $20 billion. That is a big commitment to two companies.
The greatest equity investor the world has ever known has put $20 billion into IBM and Wells Fargo, and these companies are still trading reasonably close to the price at which Buffett has recently been buying. Buffett clearly thinks these two are very fat pitches.
It will be fascinating to see what that $20 billion invested is worth twenty years from now. I generally like to invest in smaller companies where undervaluation can be more extreme, but given the size of Buffett's investment in these two, they might be worth more than a second look.