3 things investors can learn from Warren Buffett

Would you take investing advice from someone who was rejected by Harvard Business School, plays bridge for 12 hours each week, and drinks over 60 ounces of Coca-Cola daily? What if I told you that same person is Warren Buffett?

Warren Buffett is the chairman and CEO of Berkshire Hathaway (BRK.A). Buffett is a phenomenon when it comes to investing. Even though Berkshire today is among the 10 largest public companies in the world, it did not start as a diversified holding company. It was founded as a textile manufacturing company and largely remained one until Buffett and his investment firm took control in 1965. Since then, Buffett has expanded the business into other industries and acquired companies to make Berkshire Hathaway the successful conglomerate it is today.

Here are just a few things that investors of all experience levels can learn from Buffett.

1. Don’t overpay for stocks, and be patient

Buffett has countless investing dogmas and philosophies. But nothing speaks more truth and volume than his golden rule: “Rule No. 1 is never lose money. Rule No. 2 is never forget Rule No. 1.”

This might be an easy rule to follow if you are an investing master like Buffett himself, but for the rest of us, it may seem like an impossible goal to accomplish. And truth be told, even Buffett has made losing investments in the past. But there is a deeper truth to this golden rule: Because no investment is without risk, approach investing sensibly.

That means a few things. First, research your investments-in other words, know your companies. Do not get caught up in a world of speculation, says Buffett. Being an informed and decisive investor will deliver greater financial gains in the long term.

Then, make sure you’re not overpaying for a stock. Instead, demand a margin of safety. A margin of safety can be achieved when an investor purchases a stock that is believed to be trading lower than its intrinsic value.

For example, if you believe a company to be worth $50 per share, then buying the company at any price below $50 will give you a margin of safety and that margin gets wider the lower your purchased price is. If you buy that company at $40 per share, then you have a $10, or 20%, margin of safety. This is crucial because it offers investors a room for error when purchasing stocks and Buffett believes this principle to be the cornerstone of investment success.

Once you have done your research and purchased companies that provide a margin of safety, hold onto them. In investing, time is your best friend. Being patient and having your portfolio grow over time with compound interest is one of the best lessons Buffett teaches us. Some of Buffett’s investments have been in his portfolio for almost 50 years. He purchased See’s Candies in 1972 and purchased more than $1 billion worth of Coca-Cola (KO) stock in 1988, both of which he is still holding today.

2. Favour companies with moats

Buffett has always looked for companies that he understands to have competitive advantages over others.

"The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors."

Since his purchase of Berkshire Hathaway, Buffett has excelled at identifying and understanding companies with moats.

As Karen Wallace, Morningstar’s Director of Investor Education, explains: “What has traditionally benefited Berkshire has been the firm's ability to sniff out companies with moats, and take the excess cash flows generated by these companies and invest them back into projects that earn more than their cost of capital over extended periods of time.”

At Morningstar, we believe economic moats are crucial in evaluating companies because they tell us a company’s competitive advantage over others and how sustainable that advantage is.

Companies can establish moats through many different avenues, such as their cost advantage or their intangible assets like brand value.

3. When in doubt, index

Even with the first two pieces of advice from Buffett, investing in individual stocks is not easy. It can take a good deal of time to stay on top of individual stock investments-and if you’re not diversified enough, the risk of loss can be sizable.

That is why this last lesson might be the best one of them all: When in doubt, index.

Buffett has advocated for index funds on many occasions. In Berkshire's 2016 shareholder letter, he said: “Over the years, I’ve often been asked for investment advice, and in the process of answering I’ve learned a good deal about human behavior. My regular recommendation has been a low-cost S&P 500 index fund.”

Index funds are designed to track the performance of the benchmark index, like the S&P 500 or the S&P/ASX200.

Low-cost index funds can offer diversified portfolios with less risk than investing in individual securities.

A broad market, low-cost index fund is a great core holding in any equity investor’s portfolio: It’ll provide you with access to the entire stock market in just one investment.