5 stock-market rules that Warren Buffett insists you follow

By JohnCoumarianos

Warren Buffett’s 50th annual Berkshire Hathaway shareholder letter included technical discussions about the insurance industry and other businesses Berkshire owns, but as usual it also contained some important lessons for individual investors, including:

1. A stock is a business, not a piece of paper
 
First, although it seems banal to say, a stock is an ownership unit of a business. Early in the letter Buffett remarks about Berkshire’s BRK.A, +0.87% BRK.B, -0.04%  intrinsic value, saying that computing intrinsic value of a business isn’t an exact science. But Buffett mentions earnings per share and quality of management as touchstones. The latter will presumably maintain profitability and not waste money.

The lesson for investors is that a stock represents the value of a business’s future earnings. You should own it for that reason, and not because you think you can capitalize on its short-term gyrations, which generally have nothing to do with its business value. 

Although they can be crazy in the short term, stock prices are ultimately governed by the profits their underlying businesses generate, and you should treat them that way. (Buffett doesn’t say it in this context, but he has said in the past that market craziness can be a good thing for those who can calculate intrinsic value coolly. Price gyrations provide opportunities to buy at unreasonably low prices and sell at unreasonably high prices.)

2. Stocks serve as inflation protection over the long haul

 

Buffett remarks that from 1964 through 2014, the S&P 500 SPX, +0.12%  , including dividends, generated a return of more than 11,000%. Over that same period of time, the U.S. dollar DXY, +0.51%   lost 87% of its purchasing power, meaning it now costs $1 to buy what in 1965 cost 13¢.

According to Buffett, it has been far more profitable to invest in a collection of American businesses for the past 50 years . It seems likely that the next 50 years will present the same result.

Investors should remember that U.S. stocks didn’t do well in the 1970s, when inflation was rocketing. But Buffett is clearly correct in arguing that stocks certainly improved the purchasing power of their owners over the half-century period from 1964. 

Finally, although stocks may not be priced to deliver outstanding returns at any given moment, Buffett adds the phrase “bought over time” when talking about accumulating stocks. Investors should take that to mean regular periodic investments in stocks will likely turn out fine over a multi-decade period.

3. Volatility is not risk

 

Investors must tolerate far greater volatility in stocks than in securities tied to U.S. currency. But it’s clear that securities tied to the value of U.S. currency have presented truer risk to one’s financial well-being over the past half-century.

If you need money for a home purchase or to fund tuition payments over the next few years, then short-term bonds and cash are required. Stocks’ volatility VIX, -1.34%  makes them inappropriate for short-term goals. 

But if you have a long time frame and can make regular investments, then the risk to your financial well-being is in not owning stocks. So if you’re relatively young, and you’re contributing to a 401(k), for example, you’ll do yourself a favor in old age by making contributions to stocks now and periodically through your life. 

4. Keep a multi-decade time horizon

 

Buffett thinks long-term. And that’s not simply because this year’s letter marks the 50th anniversary of his having taken control of Berkshire. Being able to have a longer time horizon allows you to tolerate the volatility that stocks necessarily present, and reap the inflation-beating rewards they deliver.

5. Keep an eye on fees, and use index funds

 

Buffett is particularly ruthless this year in his discussions of investment bankers, asset managers, and advisers. He remarks that although there are some excellent money managers (presumably he’s counting himself), it’s difficult to identify them ahead of time or know whether their results are due to skill or luck.