This article was taken from the July 2014 issue of Wired magazine. Be the first to read Wired's articles in print before they're posted online, and get your hands on loads of additional content by subscribing online.
Contrary to what some have argued, Warren Buffett did not become the Oracle of Omaha by sheer luck. To figure out how Buffett chooses which companies to invest in, Lasse Heje Pedersen, a professor at New York University and CopenhagenBusiness School, created the following formula, wherein the excess return of Berkshire Hathaway (of which Buffett is chairman and CEO) stock is decomposed into its market exposure (MKT), its reliance on small stocks versus big stocks (SMB), the tendency to buy cheap stocks (captured by the value factor HML), upward trending stock (captured by the momentum factor UMD), safe stocks (BAB), and quality stocks (QMJ), and the unexplained residual (epsilon). Regardless of the market's ups and downs, Buffett has bought stocks that were low risk, cheap and high-quality, and boosted returns by using leverage. If you fancy trying it, turn the page for a few Buffett-inspired investing strategies.
Find the right price
Look through accounting numbers and see which stocks have been consistently profitable and which are trading at a relative discount. Then divide the stock price by the company's book value.
If it's in the lowest quintile compared to other stocks you've performed the same calculation on, Pedersen says, "that would be an interesting stock".
Consider leverage carefully
Throughout his career, Buffett applied a 1.6-to-1 leverage -- borrowing capital to wager a greater bet on an investment paying off -- to multiply his stock returns. This accounts for a great deal of his success. Most, however, do not have access to the kind of leverage Buffett enjoys. Individuals might do better to skip the leverage and accept lower absolute returns with less risk.
Diversify... but not too much
For an individual investor, holding 50 to 100 stocks in different companies (in different industries or the same) should be safe; beyond that, the benefits of diversification may begin to diminish.
If you don't have enough capital to pursue high diversification, however, then buying a passive index fund could be an alternative.
Don't obsess over Sharpe ratios
Buffett's Sharpe ratio -- a measurement of risk-adjusted performance that indicates whether a portfolio's returns are due to taking excess risk or by pursuing smart investments -- is 0.76.
Many managers claim to achieve ratios of 1 or 2, but Buffett's lower ratio reflects his dedication to realistic goals and longer-term gains, with buffers built in to weather temporary market downturns
Balance risk with potential gains
Create a spreadsheet simulating your potential portfolio. If you have returns from the last five years for the shares you're interested in, you can calculate the risk you would have taken if you'd bought those shares five years ago. Explore the same question by adding and subtracting stocks and diversifying across more companies to find a low-risk solution.
Embrace temporary losses
Buffett's success has not been consistent. From 1998 to 2000, Berkshire Hathaway's market value plummeted 44 per cent before rebounding. Where others may interpret such difficulties as meaning it's time to quit, Buffett prevailed through tough periods and resisted any urge to pull out of the game. This longer-term outlook ultimately allowed him to dominate the market.
This article was originally published by WIRED UK
