If you've been searching for a way to replicate the unparalleled investing success of Warren Buffett, you may find the answer written in a new study.
In a paper titled "Buffet's Alpha," authors Andrea Frazzini and David Kabiller from AQR Capital Management and Lasse Pedersen from New York University claim that they have solved the puzzle of Buffett's performance. They analyzed the investor's record since his purchase of Berkshire Hathaway in 1964. While the the researchers took multiple factors into consideration, they said that the core of Buffett's investment strategy could be broken down into two major components.
First, according to the authors, any stock that Buffett chooses must be cheap, low-risk and high quality. Although Frazzini, Kabiller and Pedersen did not cite any specific investments that met that criteria, in a Motley Fool article, analyst John Maxfield provided the example of Wells Fargo. In 1990, in the midst of a banking crisis, Berkshire Hathaway purchased a 10 percent interest in Wells Fargo for $290 million. Although its stock price had fallen 50 percent since the beginning of that year (making it cheap), Wells Fargo still had a strong business in its home state of California and a skilled group of managers and executives.
The second part of the formula is a bit less straightforward. The authors argue that a large part of Buffet's investing strategy calls for purchasing stocks "on margin." This means borrowing money to buy more shares than could have otherwise been purchased. The researchers found that for other investors to match Buffett's returns, they would need to borrow enough to own $160 in stocks for every $100 in portfolio value. Buffett has been able to do this because he can simply borrow from other parts of his business. This strategy is also best used on stocks that are less risky than the market as a whole.
Many critics of Buffett have said that individual investors are not able to replicate his success because they cannot buy into private companies – which take up a sizable proportion of Berkshire Hathaway's holdings. According to the study's authors, however, this assertion simply isn't true.
"Buffett's returns appear to be neither luck nor magic, but, rather, reward for the use of leverage combined with a focus on cheap, safe, quality stocks," states the report. "Decomposing Berkshires' portfolio into ownership in publicly traded stocks versus wholly-owned private companies, we find that the former performs the best, suggesting that Buffett's returns are more due to stock selection than to his effect on management."
The exact investment formula devised by the research team isn't feasible for most individual investors,as it requires owning a large and diverse group of assets. It can also be challenging for one person to manage a portfolio that relies on "on margin" purchases. It is possible for an individual trader to follow Buffett's example without actually borrowing money. If you have cash in your portfolio, for example, you could use it to buy a sizable number of shares in a company.
A major takeaway from this study is that most people can follow Buffett's lead. They need to be patient and avoid making irrational decisions. As the study states, Buffett's success cannot be attributed to luck or magic, meaning that with time and research, most investors can pick a group of successful stocks.
Whether or not you're interested in following the formula that may have given Buffett so much success, you must remember the importance of actively managing your portfolio. By using SmartStops' stock portfolio software, you can reduce your risk of being severely affected by market volatility.
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