Many "experts" say that they can help you invest like the legendary Warren Buffett. Most, unfortunately, have no clue how he actually does it.
Even those few who do understand his deep-value investing style are holding something back from you. They'll tell you how you can invest like Warren Buffett while omitting a key detail:
You shouldn't try to.
I know that's heresy in an era when the Oracle of Omaha is rightfully lauded as one of the world's greatest, but simply mirroring what he does will not get you where you want to go. Chances are, it won't produce the returns he gets either.
Here are three reasons you shouldn't try to invest like Warren Buffett.
Reason No. 1: Buffett Plays by Different Investing Rules
It's well-known that Berkshire Hathaway has averaged an annual return of more than 20% in the 50 years since Buffett launched it. According to Buffett's 2015 letter to shareholders, the precise number is 21.6%, including a 27% gain for Berkshire Hathaway's stock last year.
No ifs, ands, or buts about it… that's a fabulous track record over a very long period of time. It's consistent, it's undeniably robust, and it's worth noting that the S&P 500's average annual gain over the same time frame was only 9.9%.
However, it's also misleading.
There are dozens of books that will tell you Buffett has his method down cold and that he's a master at planning long-term moves and spotting undervalued companies with low-risk, high-upside prospects.
But if Buffett were given a dose of truth serum before being asked to divulge his investing secret at a TED Talk, I suspect he'd give a one-word answer: leverage. Without that, his returns wouldn't be all that great. In fact, according to The Economist, they would have been "unspectacular."
People forget that Berkshire Hathaway, in addition to being a conglomerate holding company with a vast array of investments, is also an insurance company. Like all insurance companies, it commands a float – the premiums paid by policyholders, some of which will be paid out later as benefits.
Berkshire Hathaway's float – which now stands at a formidable $84 billion – essentially functions as a massive pool of capital it can borrow at an estimated 2.2% interest. That's three full percentage points and then some below the going rate if you or I were to try and obtain similar financing, or the average short-term financing costs of the United States government over the same time frame, according to The Economist.
In other words, Buffett is banking the big bucks because he's leveraged up to his eyeballs and, like most insurance companies, has a really large investment company operating by virtue of the insurance premiums it collects.
Let me give you an example of what a difference this makes and why leverage is a dirty little secret.
Imagine you have $1 million to invest in a promising company. So you take the plunge, buy shares, and enjoy the $200,000 in profits a year later after it's appreciated by 20% and you've cashed out.
Now imagine if your leverage is 2:1. The $1 million you invested is still worth $1.2 million at the end of the year, only you've invested $500,000 instead of the initial million. That means your profit on the same 20% move is actually 40% on your money.
According to New York University researchers and ARQ Management, Berkshire Hathaway has historically levered up around 60%. That means that Buffett's profits are, on average, about 60% higher than they would have been had he used only his own money and no leverage.
About the Author
Keith Fitz-Gerald has been the Chief Investment Strategist for the Money Morning team since 2007. He's a seasoned market analyst with decades of experience, and a highly accurate track record. Keith regularly travels the world in search of investment opportunities others don't yet see or understand. In addition to heading The Money Map Report, Keith runs High Velocity Profits, which aims to get in, target gains, and get out clean, and he's also the founding editor of Straight Line Profits, a service devoted to revealing the "dark side" of Wall Street... In his weekly Total Wealth, Keith has broken down his 30-plus years of success into three parts: Trends, Risk Assessment, and Tactics – meaning the exact techniques for making money. Sign up is free at totalwealthresearch.com.