The real risk an investor must assess is whether his after-tax receipts from an investment holding period, give him at least as much purchasing power as he had to begin with, plus a decent interest on that initial money.
Remember Buffett’s advice “If you are a know-something investor, able to understand business economics and to find five to ten sensibly priced companies that possess important long-term competitive advantages, conventional diversification (broadly based active portfolios) makes no sense for you.” I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices-the businesses he understands best and that present the least risk, along with the greatest profit potential.
Our motto is: “If at first you do succeed, quit trying.”
The best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite-that is, consistently employ ever-greater amounts of capital at very low rates of return. Unfortunately, the first type of business is very hard to find: Most high-return businesses need relatively little capital. Shareholders of such a business usually will benefit if it pays out most of its earnings in dividends or makes significant stock repurchases.
According to Buffett, “Modern portfolio theory tells you how to be average. But I think almost anybody can figure out how to do average in the fifth grade.”
Warren Buffett gives us some tips to limit the risks:
- “Beware of companies displaying weak accounting.”
- “Unintelligible footnotes.” If you can’t understand them, he says, don’t assume it’s your shortcoming; it’s a favored tool for hiding something management doesn’t want you to know.
- “Be suspicious of companies that trumpet earnings projections and growth expectations.” No one knows future, and any company official who claims to do so; don’t trust.