Summary Notes The Warren Buffet Portfolio: Mastering the Power of the Focus Investment Strategy

By Robert G. Hagstrom Structure and Cognition Portfolio Management Intellectual Fortitude Understanding of price volatility and its effect on individual behaviour Personal temperament Probability Psychology Forecasting Chapter 1 Focus Investing: we just focus on a few outstanding companies. Were focus investors. Warren Buffet Choose a few stocks that are likely to produce above-average returns over the long haul, concentrate the bulk of your investments in those stocks, and have the fortitude to hold steady during any short-term market gyrations. Find Outstanding Companies Analysis of the economics of the underlying business Applying the fundamental principles o ROE o Earnings history and bright prospects (stability + ability to increase) Sustainable competitive advantages o Low or no debt o Cash flow o Managements Capital Allocation history o Price trading at a significant discount to valuation Margin for Safety Good companies are high-probability events Business Tenets Is the business model simple and understandable? Does the business have a consistent operating history? Does the business have favourable long-term prospects? Management Tenets

 Is management rational? Is management honest and candid? Does management resist the institutional imperitive? Financial Tenets Focus on ROE, not EPS Calculate owner earnings Look for companies with high profit margins For every dollar retained, make sure the company has created at least one dollar of market value Market Tenets What is the value of the business? Can the business be purchased at a significant discount to its value? "A Few No more than 15 John Maynard Keynes, the British economist: In 1934, Keynes wrote

to a business associate: "It is a mistake to think one limits one's risks by spreading too much between enterprises about which one knows little and has no reason for special confidence . . . . One's knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which I personally feel myself entitled to put full confidence."4 Phil Fisher was known for his focus portfolios; he always said he preferred owning a small number of outstanding companies that he understood well to owning a large number of average ones, many of which he understood poorly. "I knew the more I understood about the company the better off I would be." 5 As a general rule, Fisher limited his portfolios to fewer than ten companies, of which three or four often represented 75 percent of the total investment. Less is more
Place large bets on High-Probability Events When you encounter a strong opportunity, the only reasonable course is to make a large investment Like all great investors Fisher was very disciplined. In his drive to understand as much about a company, he made countless field trips to visit companies he was interested in. If he liked what he saw, he didnt hesitate to invest a significant amount of money in the company. With each investment you make, you should have the courage and conviction to place at least 10% of your net worth in that stock. Warrant Buffet The Kelly Optimization Model Allocate investment funds proportionately, place the biggest bets on the highest-probability events

In shorter periods, we realize that changes in interest rates, inflation, or the near term expectation for a companys earnings can affect share prices. But as the time horizon lengthens, the trend-line economics of the underlying business will increasingly dominate its share price. Chapter two The High Priests of Modern Finance Risk Buffett defines risk as the possibility of harm or injury. This is a factor of the intrinsic value risk of the business, not the price behaviour of the stock. The real risk, Buffett says, is whether after-tax returns from an investment will give him [an investor] at least as much purchasing power as he had to begin with, plus a modest rate of interest on that initial stake. In Buffetts view, harm or injury comes from misjudging the four primary factors that determine the future profits of your investment (The fundamental principles), plus uncontrollable, unpredictable effect of taxes and inflation. Risk is inextricably linked to an investors time horizon. If you buy a stock today, he explains, with the intention of selling it tomorrow, then you have entered into a risky transaction. The odds of predicting whether share prices will be up or down in a short period are not greater than the odds of predicting the toss of a coin; you will lose half of the time. However, says Buffett, if you extend your time horizon out to several years, the probability of its being a risky transaction declines meanifully, assuming of course that you have made a sensible purchase. If you asked me to assess the risk of buying Coca-Cola this morning and selling it tomorrow morning, Buffet says, td say that thats a very risky transactions. But in Buffetts way of thinking, buying Coca-Cola this morning and holding for 10 years, carries zero risk.

Is it a Good Investment? To determine the probability of achieving a return on your intial stake, keep in mind: 1. The certainty with which the long-term economic characterisitcs of the business can be evaluated 2. The certainty with which management can be evaluated, both as to its ability to realise the full potential of the business and the wisely employ its cash flows 3. The certainty with which management can be counted on the channel the rewards from the business to the shareholders rather than to itself 4. The purchase price of the business

We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort level he must feel with its economic characteristics before buying into it." 12 That is, by purposely focusing on just a few select companies, you are better able to study them closely and

understand their intrinsic value. The more knowledge you have about your company, the less risk you are likely to be taking. "Diversification serves as protection against ignorance," explains Buffett. "If you want to make sure that nothing bad happens to you relative to the market, you should own everything. There is nothing wrong with that. It's a perfectly sound approach for somebody who doesn't know how to analyze businesses." In many ways, modern portfolio theory protects investors who have limited knowledge and understanding of how to value a business. But that protection comes with a price. According to Buffett, "It [modern portfolio theory] will tell you how to do average. But I think almost anybody can figure out how to do average in the fifth grade." Focus Portfolio Theory as Opposed to Modern Portfolio Theory Investors are not always rational; they suffer from periodic episodes of fear and greed The market is not always efficient, and therefore investors willing to study and learn are given opportunities to beat the market Risk is not price-based; it is economic-value-based The optimal portfolio is a focus portfolio that stresses big bets on high-probability events, as opposed to equally weighted bets on a mixed bag of probabilities Ben Graham, You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right. Chapter Three The Superinvestors of Buffettville
Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ. Warren Buffett Begin with the idea of selecting the best possible stocks and then let the portfolio form around these selections.

Focus portfolios that concentrate on high-probability events give the optimal returns. Conversely, attempts to dilute the portfolio with more names in mindlessly equal installments will likely drive returns closer to a market rate of return. When you adjust these returns by subtracting commissions and expenses, you begin to appreciate how difficult it is to outperform the market with hundreds of stocks that are constantly being bought and sold.

Chapter Four A Better Way to Measure Performance

"A prolonged suspension of trading in securities we hold would not bother us any more than does the lack of daily quotations for World Book or Fechheimer [two Berkshire Hathaway subsidiaries]. Eventually our economic fate will be determined by the economic fate of the business we own, whether our ownership is partial [in the form of shares of stock] or total."10 If you owned a business and there was no daily quote to measure its performance, how would you determine your progress? Likely you would measure the growth in earnings, or perhaps the immprovement in operating margins, or a reduction in capital expenditures. You simply would let the economics of the business dictate whether you are increasing or decreasing the value of your business. In Buffett's mind, the litmus test for measuring the performance of a private company is no different than measuring the performance of a publicly traded company. "Charlie and I let our marketable equities tell us by their operating resultsnot by their daily, or even yearly, price quotationswhether our investments are successful," explains Buffett. "The market may ignore business success for a while, but it eventually will confirm it."11 This bears out Buffett's thesis that, given enough time, a strong business will eventually command a strong price. He cautions, though, that the translation of earnings into share price is both "uneven" and "unpredictable." Although the relationship between earnings and price strengthens over time, it is not always prescient. ''While market values track business values quite well over long periods," Buffett notes, "in any given year the relationship can gyrate capriciously." 12 Sixty-five years ago, Ben Graham gave us the same lesson: "In the short run the market is a voting machine but in the long run it is a weighing machine."13 It is clear that Buffett is in no hurry to have the market affirm what he already believes is true. "The speed at which a business's success is recognized, furthermore, is not that important as long as the company's intrinsic value is increasing at a satisfactory rate," he says. "In fact, delayed recognition can be an advantage: It may give us the chance to buy

more of a good thing at a bargain price."14 "The goal of each investor," says Buffett, "should be to create a portfolio (in effect, a 'company') that will deliver him or her the highest possible look-through earnings a decade or so from now." 15 According to Buffett, since 1965 (the year Buffett took control of Berkshire Hathaway), the company's look-through earnings have grown at almost the identical rate of the market value of its securities. However, the two have not always moved in lockstep. There have been many occasions when earnings moved ahead of prices (when Ben Graham's famous Mr. Market was unduly depressed). At other times, prices moved far ahead of earnings (when Mr. Market was uncontrollably enthused). What is important to remember is that the relationship works over time. "An approach of this kind," counsels Buffett, "will force the investor to think about long-term business prospects rather than short-term market prospects, a perspective likely to improve results."
16

Buffett's Measuring Stick When Buffett considers adding an investment, he first looks at what he already owns, to see whether the new purchase is any better. What Berkshire owns today is an economic measuring stick used to compare possible acquisitions. Charlie Munger. "For an ordinary individual, the best thing you already have should be your measuring stick." What happens next is one of the most critical but widely overlooked secrets to increasing the value of your portfolio. "If the new thing [you are considering purchasing] isn't better than what you already know is available," says Charlie, "then it hasn't met your threshold. This screens out 99 percent of what you see.'' (OID)17 You can define your own personal economic benchmark in several different ways: look through earnings, return on equity, or margin of safety, for example. When you buy or sell a company in your portfolio, you have either raised or lowered your economic benchmark. The job of a portfolio manager, who is a long-term owner of securities and believes future stock prices eventually match with underlying economicsand that manager might well be you is to find ways to raise the benchmark. "That's an enormous thoughtconserver," says Munger, "and it's not taught at the business schools by and large." (OID) 18 Two Good Reasons to Move Like a Sloth Focus investing is necessarily a long-term approach to investing. If we were to ask Buffett what he considers an ideal holding period, he would

answer "Forever"so long as the company continues to generate aboveaverage economics and management allocates the earnings of the company in a rational manner. "Inactivity strikes us as intelligent behavior," he explains. "Neither we nor most business managers would dream of feverishly trading highly profitable subsidiaries because a small move in the Federal Reserve's discount rate was predicted or because some Wall Street pundit has reversed his views on the market. Why, then, should we behave differently with our minority positions in wonderful businesses?" 20 If you own a lousy company, you require turnover because, without it, you end up owning, for a long term, the economics of a sub-par business. But if you own a superior company, the last thing you want to do is to sell it. "When carried out capably, a [low-turnover] investment strategy will often result in its practitioner owning a few securities that will come to represent a very large portion of his portfolio," explains Buffett. "This investor would get a similar result if he followed a policy of purchasing an interest in, say, 20 percent of the future earnings of a number of outstanding college basketball stars. A handful of these would go on to achieve NBA stardom, and the investor's take from them would soon dominate his royalty stream. To suggest that this investor should sell off portions of his most successful investments simply because they have come to dominate his portfolio is akin to suggesting that the Bulls trade Michael Jordan because he has become so important to the team." 21 This "sloth-like" approach to portfolio management may appear quirky to those accustomed to actively buying and selling stocks on a regular basis, but it does have two important economic benefits, in addition to growing capital at an above-average rate: 1. It works to reduce transaction costs. 2. It increases after-tax returns. Each advantage by itself is extremely valuable; their combined benefit is enormous. Compounding Tax-Free Buffett asks us to imagine what happens if you buy a $1 investment that doubles in price each year. If you sell the investment at the end of the first year, you would have a net gain of $.66 (assuming you're in the 34 percent tax bracket). In the second year, you reinvest $1.66 and it doubles in value by year-end. If the investment continues to double each year, and you continue to sell, pay the tax, and reinvest the proceeds, at the end of twenty years you would have a net gain of $25,200 after paying taxes of $13,000.

If, on the other hand, you purchased a $1 investment that doubled each year and was not sold until the end of twenty years, you would gain $692,000 after paying taxes of approximately $356,000. The Amazing Effect of Compounding Start with a $1 investment that doubles in value every year. 1. Sell the investment at the end of the year, pay the tax, and reinvest the net proceeds. Do the same thing every year for twenty years. End up with $25,200 clear profit. Or 2. Don't sell anything. At the end of twenty years, end up with $692,000 after-tax profit. You end up with a great deal more profit if you don't take your gain each year but just let the money compound To achieve high aftertax returns, investors need to keep their average annual portfolio turnover ratio somewhere between zero and 20 percent. What strategies lend themselves best to low turnover rates? One possible approach is a passive, low turnover index fund. Another is a focus portfolio. "It sounds like premarital counseling advice," say Jeffrey and Arnott, "namely, to try to build a portfolio that you can live with for a long, long time."25 "In investment management today," explains Charlie Munger, "everybody wants to not only win, but to have a yearly outcome path that never diverges very much from a standard path except on the upside." Well, says Charlie, "from the viewpoint of a rational consumer, the whole system is bonkers and it draws a lot of talented people into socially useless activity.'' (OID)26

Year
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Start of Period $1.00 $1.66 $2.76 $4.57 $7.59 $12.60 $20.92 $34.73 $57.66 $95.71 $158.88 $263.75 $437.82 $726.78 $1,206.46 $2,002.73 $3,324.52 $5,518.71 $9,161.06 $15,207.35

End of Period $2.00 $3.32 $5.51 $9.15 $15.19 $25.21 $41.85 $69.47 $115.32 $191.43 $317.77 $527.50 $875.64 $1,453.57 $2,412.92 $4,005.45 $6,649.05 $11,037.42 $18,322.11 $30,414.71

Capital Gain $1.00 $1.66 $2.76 $4.57 $7.59 $12.60 $20.92 $34.73 $57.66 $95.71 $158.88 $263.75 $437.82 $726.78 $1,206.46 $2,002.73 $3,324.52 $5,518.71 $9,161.06 $15,207.35

Tax Liability (34% TR) $0.34 $0.56 $0.94 $1.56 $2.58 $4.29 $7.11 $11.81 $19.60 $32.54 $54.02 $89.67 $148.86 $247.11 $410.20 $680.93 $1,130.34 $1,876.36 $3,114.76 $5,170.50 $13,004.08

Gain After Tax $0.66 $1.10 $1.82 $3.02 $5.01 $8.32 $13.81 $22.92 $38.05 $63.17 $104.86 $174.07 $288.96 $479.68 $796.26 $1,321.80 $2,194.19 $3,642.35 $6,046.30 $10,036.85

Proceeds to Reinvest $1.66 $2.76 $4.57 $7.59 $12.60 $20.92 $34.73 $57.66 $95.71 $158.88 $263.75 $437.82 $726.78 $1,206.46 $2,002.73 $3,324.52 $5,518.71 $9,161.06 $15,207.35 $25,244.21

Year 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Start of Period $1.00 $2.00 $4.00 $8.00 $16.00 $32.00 $64.00 $128.00 $256.00 $512.00 $1,024.00 $2,048.00 $4,096.00 $8,192.00 $16,384.00 $32,768.00 $65,536.00 $131,072.00 $262,144.00 $524,288.00

End of Period $2.00 $4.00 $8.00 $16.00 $32.00 $64.00 $128.00 $256.00 $512.00 $1,024.00 $2,048.00 $4,096.00 $8,192.00 $16,384.00 $32,768.00 $65,536.00 $131,072.00 $262,144.00 $524,288.00 $1,048,576.00

Capital Gain N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A $1,048,575.00

Tax Liability (34% TR) N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A $356,515.50

Gain After Tax N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A $692,059.50

Proceeds to Reinvest N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A $692,060.50

Chapter Five The Warren Buffett Way Tool Belt To calculate the current value of a business, you start by estimating the cash flows that you expect will occur over the life of the business and then discount that total backward to today, using an appropriate discount rate. "If we could see, in looking at any business, its future cash inflows and outflows between the business and its owner over the next 100 years, or until the business is extinct, and then could discount them back at the appropriate interest rate, that would give us a number for intrinsic value," says Buffett. (OID) 1 This concept, postulated by John Burr Williams in The Theory of Investment Value, is as true today as it was when first written more than sixty years ago. Some people find it easier to compare this process to the one used when valuing a bond. The mathematics are the same. Instead of cash flow, bonds have coupons; instead of an indefinite period, bonds have a finite life, at which point they return the invested capital back to the owners. "It would be like looking at a bond with a whole bunch of coupons on it that matured in a hundred years," explains Buffett. "Well, businesses have coupons that are going to develop into the future, too. The only problem is that they aren't printed on the instrument. Therefore, it's up to the investor to estimate what those coupons are going to be." (OID)2 Estimating the amount of the coupons, then, is a matter of two numbers: the probable future earnings, and the discount rate used to bring those future earnings back to present dollars. For the second number, the discount rate, Buffett generally uses the rate then current for long-term government bonds. Because the certainty that the U.S. Government will pay its coupon over the next thirty years is virtually 100 percent, we can say that this is a risk-free rate. As Buffett explains, "We use the riskfree rate merely to equate one item to another." (OID) 3 According to Buffett, it is simply the most appropriate yardstick with which to measure a basket of all different investment types: government bonds, corporate bonds, common stocks, apartment buildings, oil wells, and farms. Buffett does not adjust the discount rate for uncertainty. If one investment appears riskier than another, he keeps the discount rate constant and, instead, adjusts the purchase price. He would, in other words, obtain his margin of safety not by including a premium for "equity risk," as the Capital Asset Pricing Model (CAPM) requires, but by buying at a lower purchase price to begin with. "If you understand a business and if you can see its future perfectly, then you obviously need very little in the way of margin of safety," says Buffett. "Conversely, the more vulnerable the

business, the larger the margin of safety you require." (OID)4 Management Tenet: Can We Value Managers? Managers who behave like owners tend not to lose sight of the company's prime objectiveincreasing shareholder valueand they tend to make rational decisions that further that goal (1) rationality, (2) candor, and (3) resisting the institutional imperative if a company generates high returns on equity, the duty of management is to reinvest those earnings back into the company, for the benefit of shareholders. However, if the earnings cannot be reinvested at high rates, management has three options: (1) ignore the problem and continue to reinvest at below-average rates; (2) buy growth; or (3) return the money to the shareholders, who then might have a chance to reinvest the money elsewhere at higher rates. In Buffett's mind, only one choice is rational, and that is option 3 If the idea of measuring management still seems vague, Buffett offers a few tips: Review annual reports from a few years back, paying special attention to what management said then about strategies for the future. Compare those plans to today's results: How fully were they realized? Compare the strategies of a few years ago to this year's strategies and ideas: How has the thinking changed? Compare the annual reports of the company you are interested in with reports from similar companies in the same industry. It is not always easy to find exact duplicates, but even relative performance comparison can yield insights. Warren Buffett's approach to picking stocks has changed very little over the past twenty years. He thinks about the company, the management, the financials, and the asking pricein that order Value vs Growth Investing The value of a stock, Buffett has explained on several occasions, is the net cash flows of the investment that occur over the life of the investment,

discounted at the appropriate interest rate. Growth, he points out, is simply a part of the calculation that pertains to the cash flow. "In our opinion," says Buffett, "the two approaches [value and growth] are joined at the hip."
8.

Chapter Six The Mathematics of Investing Subjective interpretation of probabilities Probabilistic statements describe our degree of belief about the event. When it isnt possible to enough repetitions of a certain event to get an interpretation of probability based on frequency, we have to rely on our own good sense "Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we're trying to do," says Buffett. "It's imperfect, but that's what it is all about." 10 Risk Arbitrage A pure arbitrage is nothing more than profiting from the discrepancy in the price of a security quoted in two different markets. For example, commodities and currencies are quoted in several different markets around the world. If two separate markets quoted a different price on the same commodity, you could buy in one market, sell in the other market, and pocket the difference. Risk arbitrage, which is the form more commonly practiced today, involves announced corporate mergers or acquisitions. (Some speculators practice risk arbitrage on unannounced corporate events, but this is an area that Buffett avoids and so shall we.) "My job," says Buffett, "is to assess the probability of the events [announced mergers] actually transpiring and the gain/loss ratio." Buffett's decision process is an exercise in subjective probability. He explains: "If I think an event has a 90 percent chance of occurring and there is 3 points on the upside, and there is a 10 percent chance that it will fall through, and there's 9 points on the downside, then that's $.90 off of $2.70 leaving $1.80 mathematical expectation." (OID)13 Next, says Buffett, you have to figure in the time span involved, and then relate the return of the investment to other investments available to you. If you bought one share of Abbott Company at $27, according to Buffett's mathematics there is a potential 6.6 percent return ($1.80/$27). If the deal was expected to close in six months, the annualized return on the investment would be 13.2 percent. Buffett would then compare the return

from this risk arbitrage with other returns available to him. We can see quite clearly that Buffett's risk arbitrage estimates are subjective probabilities. There is no frequency distribution in risk arbitrage. Every deal is different. Every circumstance requires different estimations. Even so, there is value to approaching the risk arbitrage deal with some rational mathematical calculation. When the probabilities of success are very high, make a big bet. The Kelly Optimisation Model Often called the optimal growth strategy, is based on the concept that if you know the probability of success, you bet the fraction of your bankroll that maximizes the growth rate. It is expressed as a formula:

where 2 times the probability of winning minus 1 equals the percentage of one's bankroll that should be bet. For example, if the probability of beating the house is 55 percent, you should bet 10 percent of your bankroll to achieve maximum growth of your winnings. If the probability is 70 percent, bet 40 percent. And if you know the odds of winning are 100 percent, the model would say, bet your entire bankroll. The Kelly formula is optimal under two criteria: (1) the minimal expected time to achieve a level of winnings and (2) the maximal rate of wealth increase the underlying conceptmathematically linking degree of probability to investment sizecarries important lessons for the focus investor We have no evidence that Buffett uses the Kelly model when allocating Berkshire's capital. But the Kelly concept is a rational process and, to my mind, it neatly echoes Buffett's thinking. Buffett has counseled investors to wait until the best opportunities appear and then be willing to bet big. In any event, I have found the Kelly model useful as a mathematical explanation that yields a better understanding of the portfolio allocation process. the biggest danger in playing high-probability games is the risk of overbetting. If you judge an event has a 70 percent probability of success

when in fact it is only 55 percent, you run the risk of "gambler's ruin." The way to minimize that risk is underbettingusing a half-Kelly or a fractional-Kelly model. to summarize: 1. To receive the benefit of the Kelly model, you must first be willing to think about buying stocks in terms of probabilities. 2. You must be willing to play the game long enough to achieve its rewards. 3. You must avoid using leverage, with its unfortunate consequence. 4. You should demand a margin of safety with each bet you make. Insurance Is Like Investing "Insurance is a lot like investing," explains Buffett. "If you feel like you have to invest every day, you're going to make a lot of mistakes." To succeed in investing or in writing insurance, "You have to wait for the fat pitch." (OID) 25 "We will get hit from time to time with large losses," explains Buffett. "Charlie and I, however, are quite willing to accept relatively volatile results in exchange for better long-term earnings than we would otherwise have had. Since most managers opt for smoothness, we are left with a competitive advantage that we try to maximize. In other words, we prefer the lumpy 15 percent to a smooth 12 percent.'' 32 It's All About Odds "The model I liketo sort of simplify the notion of what goes on in a market for common stocksis the pari-mutuel system at the racetrack," as Charlie explained "If you stop to think about it, a pari-mutuel system is a market. Everybody goes there and bets and the odds are changed based on what's bet. That's what happens in the stock market." (OID)33 "Any damn fool can see that a horse carrying a light weight with a wonderful win rate and good position etc. is way more likely to win than a horse with a terrible record and extra weight and so on and so on. But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then it's not clear which is statistically the best bet. The prices have changed in such a way that it's very hard to beat the system." (OID) 34 Too often, investors are attracted to a long shot that pays incredible odds but, for any one of countless reasons, never wins the race. Or, investors

sometimes pick the sure thing without ever considering the payoff. It appears to me that the most sensible way to approach horse racing or the stock market is to lie back and wait until the good horse comes to the post with the inviting odds. Calculating Probability If the circumstance you're investigating has only a limited number of possible outcomes, calculating probability is a matter of simple arithmetic. A die has only six sides, so the probability of any one of them landing face up is one in six. If the number of possible outcomes is unlimited, and if, looking backward, you can find a large number of instances, then you can conclude probability on the basis of a frequency distribution If the number of possible outcomes is unlimited but you do not have access to enough repetitions to make a frequency distribution, then you must do a subjective interpretation, collecting as much information as you can and analyzing it thoughtfully. In this case, your probability determination coincides with your level of confidence in your analysis. Using any of these variations, you end up with a determination of the chances that the particular event will happen, expressed as a percentage: 50 percent, 70 percent, whatever. This is your estimate of probability, based on your best information at the time. But what happens if new information becomes available? Adjusting a Calculation to Integrate New Information Suppose new information comes in, and suppose it clearly suggests that the situation might have more than one outcome, depending on various circumstances. You are then faced with a decision tree: If X happens, the probability of success is 55 percent, but if Y happens, the probability would change to 70 percent. This is a Bayesian analysis. Your answer is more complex because it has several variations, but the process is the same: Take each variation, gather all the data you can, and think it through as thoroughly as you can. Then you have a probability calculation for each of the possible outcomes. Now that we know the probability, as much as it is knowable, we are ready for the second question: How much should you betin other words, how big is big?

Determining the Size of the Bet The Kelly Optimization Model will tell you how much to bet, expressed as a fraction of the total. When the situation is fluid and complex, as it is in the stock market, you may not be able to apply the formula rigidly. You will have to make allowance for the continually shifting forces. The basic notion still applies: As the probability rises, so should the amount of the investment. Now we have two big pieces of the picture: probability and investment size. One question remains: When should you make your move? Not until the odds are in your favor. Watching the Odds The horse that is favored to win the race has the highest probability, but might not be a good bet if the odds are only 3 to 2; the profit potential is not particularly exciting. But if your information leads you to believe that another horse also has a high probability of winning, and the odds are more favorable, that's when you make your big bet Probability Theory and the Market 1. Calculate probabilities. As a focus investor, you restrict yourself to a limited number of stocks because you know that, in the long run, it is your best chance of doing better than the overall market. So, when thinking about buying a new stock, your goal is to make sure your choice will outperform the market. That is the probability you are concerned with: What are the chances that this stock, over time, will achieve an economic return greater than the market? Using frequency if it is available, and subjective interpretation if it is not, make your best estimate. What you will be looking at is how closely the company you are considering matches up to the tenets of the Warren Buffett Way (see box in Chapter 1). Do the most thorough job you can of collecting information about the company. Measure it against those tenets, and convert your analysis to a number. That number represents how obvious it is to you that the company is a winner. 2. Adjust for new information. Knowing that you are going to wait until the odds turn in your favor, pay scrupulous attention to whatever the company does. Is management beginning to act irresponsibly? Are the financial decisions beginning to change? Has something happened to change the competitive landscape in which the business operates? If so, the probabilities will likely change. 3. Decide how much to invest. Out of all the funds you have available for investing in the market, what proportion should go to this

particular purchase? Start with the Kelly formula, then adjust it downward, perhaps by half. 4. Wait for the best odds. The odds of success tip in your favor when you have a margin of safety; the more uncertain the situation, the greater margin you need. In the stock market, that safety margin is provided by a discounted price. When the company you like is selling at a price that is below its intrinsic value (which you have determined in the process of analyzing probabilities), that is your signal to act. It will be obvious, I'm sure, that this process is a continuous loop. As the circumstances change, the probabilities change; with new probabilities, you might need a new margin of safety, and so you have to adjust your sense of what constitutes the best odds. If this seems too difficult, think about the hundreds of small choices you make every time you drive your car, constantly adjusting your actions in response to the situation around you. The stakes are much higheryour safety and others'yet you make these changes almost without conscious thought. In comparison, keeping up with a few companies is relatively easy. It is simply a matter of experience. "It's not given to human beings to have such talent that they can just know everything about everything all the time," says Charlie. "But it is given to human beings who work hard at itwho look and sift the world for a mispriced betthat they can occasionally find one." Furthermore, says Charlie, "The wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don't. It's just that simple." (OID) 37 Without question, Buffett's success is tied closely to numbers. "One of the advantages of a fellow like Buffett whom I've worked for all these years," confesses Charlie, "is that he automatically thinks in terms of decision trees and the elementary math of permutations and combinations." (OID)39 Most people do not. It doesn't appear that the majority of investors are psychologically predisposed to thinking in multiple scenarios. We have a tendency to make decisions categorically while ignoring the probabilities Not often will the market price Coca-Cola or any other outstanding businesses substantially below their intrinsic value. But when it does occur, you should be financially and psychologically prepared to bet big. In the meantime, you should continue to study stocks as businesses with the idea that one day the market will give you compelling odds on a good investment. "Considering what it takes to be an Inevitable," says Buffett, "Charlie and I recognize we will never be able to come up with a Nifty Fifty or even a Twinkling Twenty. To the Inevitables in our portfolio,

therefore, we add a few Highly Probables." 40 Chapter 7 The Psychology of Investing because the market is, by definition, the collective decisions made by all stock purchasers, it is not an exaggeration to say that the entire market is pushed and pulled by psychological forces. As Warren Buffett, his most famous student, explains, ''There are three important principles to Graham's approach." The first is simply looking at stocks as businesses, which "gives you an entirely different view than most people who are in the market." The second principle is the margin-of-safety concept, which "gives you the competitive edge." And the third is having a true investor's attitude toward the stock market. "If you have that attitude," says Buffett, "you start out ahead of 99 percent of all the people who are operating in the stock marketit's an enormous advantage." (OID) 1
Mr Market Allegory

What would inspire people to engage in such ineffective trading? Because it is not possible to ask each of the 10,000 people what was in their minds at the time, we cannot know their reasons. There may even be 10,000 different reasons. But we can deduce one thing with certainty: When it comes to money and investing, people frequently make errors in judgment Behavioural Finance Uses psychological theories to explain market inefficiencies Overconfidence Ask a large sample of people how many believe their skills at driving a car are above average, and an overwhelming majority will say they are excellent driverswhich leaves open the question of who the bad drivers are. Overconfident investors can make silly decisions for themselves and have a powerful effect on the market as a whole Confidence per se however is not a bad thing Overconfident investors tend to overestimate their skills and knowledge and typically rely on info that confirms their beliefs as they disregard conflicting info. They also fail to seek out info that is little known, instead relying on what info is readily available Prof Daniel Kahneman Princeton Uni One of the hardest things to imagine is that you are not smarter than average.

The reality is that not everyone can be better than average Overreaction Bias People tend to overreact to bad news and react slowly to good news E.g. negative short-term earnings report typical investors response is an abrupt, ill-considered overreaction with its inevitable effect on stock prices Thaler describes this overemphasis on the short term as myopia (medical term of nearsightedness). Leads to foolish decisions. Believes investors would be better off not receiving monthly statements. not opening the mail Part of the reason myopia provokes such an irrational response is due to our innate desire to avoid loss Loss Aversion Pain of loss is far greater than enjoyment of gain according to behaviourists Thaler and others have demonstrated that people need twice as much positive to overcome a negative. On a 50/50 bet, precisely even odds, most people will not risk anything unless the potential gain is twice as high as the potential loss o Known as asymmetric loss aversion downside has a greater impact that the upside, and it is a fundamental bit of human psychology. o Applied to the stock market means investors feel twice as bad about losing money as they feel about picking a winner Impact of loss aversion on investment decisions everyone wants to believe they made good decisions. To preserve self-image ppl hold onto bad choices too long in the vague hope that things will turn around. By not selling loser, failures are never confronted. o If you dont sell a mistake, you are potentially giving up a gain that could be earned by re-investing elsewhere o Can make investors unduly conservative especially when their time horizon is decades Mental Accounting Habit of shifting our perspective on money as surrounding circumstances change. Tend to mentally put money into different accounts and that determines how we think about using it How we decide to invest and how we choose to manage those investments has a great deal to do with how we think about money

 Must understand the psychology of misjudgment to fully understand the markets and investing. Risk Tolerance Chapter 8 The Market as a Complex Adaptive System
We've long felt that the only value of stock forecasters is to make fortune tellers look good Warren Buffett

Anyone who has observed Warren Buffett for any length of time knows that his position on forecasting is clear: Don't waste your time. Whether in regard to the economy, the market, or individual stock prices, Buffett believes firmly that forecasting has no place in investing. For over forty years, he has achieved great wealth and an unmatched performance record by simply investing in great companies while simultaneously avoiding the ruinous distractions that occur when investors become obsessed with guessing the future direction of markets. "The fact that people will be full of greed, fear or folly is predictable," says Buffett. "The sequence, however, is not." 1 Now keep in mind, Buffett does not say the future is unpredictable. After all, we do know the market will eventually reward companies able to increase their shareholders' value. But we do not know precisely when this will occur. We also can safely predict that stock prices will continue to be volatile. We just don't know if, come next year, these prices will be up or down. The Economy as a Complex Adaptive Sytem 1. First, an economy is a network system of many "agents" all acting in parallel. In an embryo, the agents are cells. In an economy, the agents are people. Both cells and people exist in environments that are produced by the interactions of other agents. The cells and the people continually react to what other agents in the system are doing, and thus the environment is never at rest. 2. Second, control of the economy is highly dispersed. There is no master cell in a developing embryo, nor is there a master controller of the economy. Yes, our economy has a Federal Reserve, and politicians can change tax laws and regulations, but the overall economy is often a result of the millions of decisions made by individuals (agents) each day. The coherent behavior within the economic system arises out of the competition or cooperation among

the agents. 3. Third, and this is considered to be a critical characteristic of complex systems, agents in a complex system accumulate experience and adapt to a changing environment. We know that generations of organisms will rearrange their tissue through evolution; so, too, will people adapt and learn from their experiences in the world. So important is this characteristic that complex systems are today routinely referred to as complex adaptive systems. It is now easy to understand how characteristics of a complex adaptive system make it impossible for the economy to ever reach equilibrium. The behavior of agents, who are constantly changing, reacting, and learning, makes it certain the economy will never be at rest. Some scientists have suggested that if the economy ever reached equilibrium, it wouldn't just be stableit would be dead. Conventional mathematical approaches, including calculus and linear analysis, are well suited to studying unchanging particles in a fixed environment. Newton's approach still works in the repeatable mechanistic world, but it has no use to those who want to understand complex adaptive systems. To understand economies, stock markets, or other complex adaptive systems, we will need to turn to experimental mathematics and nonlinear analysis. Professional Money Managers and Three Degrees of Separation John Maynard Keynes recognized sixty years ago. "Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs," he wrote, "the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view." As if trying "to guess better than the crowd how the crowd will behave" were not tricky enough, Keynes's exercise is complicated by one more variable. "It is not a case of choosing those which, to the best of one's judgement, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest," said Keynes. "We have reached the third degree where we devote our intelligence to anticipating what average opinion expects the average opinion to be. And there are some, I believe,

who practice the fourth, fifth, and higher degrees." 12 What counts today is not what you think is going to happen in the market or the economy but what you believe most people think about the markets. Buffett understands this well. "We have 'professional investors,' those who manage many billions, to thank for most of this turmoil," says Buffett. "Instead of focusing on what businesses will do in the years ahead, many prestigious money managers now focus on what they expect other money managers to do in the days ahead."13 Professor Mauboussin likens the changes in markets to a sand pile that is formed by a slow but steady pouring of sand. "Each grain," explains Mauboussin, "is like an individual agent. Insignificant in itself, it joins with other grains to produce cumulative effects. Once the pile grows past some critical point, the system falls out of balance." 26 The result is an avalanche. Pattern Recognition "If you have a truly complex system," says Brian Arthur, "then the exact patterns are not repeatable."30 Limited patterns of behavior constantly interrupted by unexpected and sometimes violent changes. Like it or not, we live in an ever-changing world. Like a kaleidoscope, patterns in this world change with some apparent order but never repeat in the exact sequence. The patterns are always new and different. How do investors maneuver in a world that lacks pattern recognition? By looking in the right place at the right level. Although the economy and the market as a whole are too complex and too large to be predictable, there are patterns at the company level that we can recognize. Inside each company, there are company patterns, management patterns, and financial patterns. If you study those patterns, in most cases you can make a reasonable prediction about the future of that company. Those are the patterns that Warren Buffett focuses on, not the unpredictable behavioral patterns of million of investors. "I have always found it easier to evaluate weights dictated by fundamentals than votes dictated by psychology," he said. 31 "We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen," says Buffett. "Thirty years ago, no one could have foreseen the huge expansion of the Vietnam War, wage and price controls, two oil shocks, the resignation of a president, the dissolution of the Soviet Union, a one-day drop in the Dow of 508 points, or Treasury bill yields fluctuating between 2.8 percent and

17.4 percent."32 Not knowing ahead of time when these events would occur did not prevent Buffett from achieving his investment performance. "None of these blockbuster events made the slightest dent in Ben Graham's investment principles," said Buffett. "Nor did they render unsound the negotiated purchases of fine businesses at sensible prices. Imagine the cost to us, if we had let a fear of unknowns cause us to defer or alter the deployment of capital."33 "A different set of major shocks is sure to occur in the next thirty years," explains Buffett. "We will neither try to predict these nor profit from them. If we can identify businesses that are similar to those we have purchased in the past, external surprises will have little effect on our long-term results.''
34

remember what Buffett says. "Face up to two unpleasant facts: the future is never clear and you pay a very high price in the stock market for a cheery consensus. Uncertainty is the friend of the buyer of long-term values."35 remember what Buffett says. "Face up to two unpleasant facts: the future is never clear and you pay a very high price in the stock market for a cheery consensus. Uncertainty is the friend of the buyer of long-term values."35 Chapter Nine Where Are the .400 Hitters? Becoming a Portfolio Manager Who Hits .400 Think of stocks as businesses. Increase the size of your investment. Reduce portfolio turnover Develop alternative performance benchmarks. Learn to think in probabilities Recognize the psychology of misjudgment. Ignore market forecasts Wait for the fat pitch. Think of Stocks as Businesses "In our view," says Buffett, "investment students need only two well-taught coursesHow to Value a Business, and How to Think About Market Prices."5 "Whenever Charlie and I buy common stocks for Berkshire, we approach the transaction as if we were buying into a private business. We look at the economic prospects of the business, the people in charge of running it, and the price we must pay."6

"Your goal as an investor should be simply to purchase, at a rational price, a part interest in an easily understandable business whose earnings are virtually certain to be materially higher, five, ten, and twenty years from now," explains Buffett. "Over time, you will find only a few companies that meet these standardsso when you see one that qualifies, you should buy a meaningful amount of stock."7 Increase the Size of Your Investment "I wouldn't want to buy anything where I wouldn't want to put 10 percent of my net worth into it," confesses Buffett. "If I don't want to put that into it, then it just isn't much of an idea." (OID)8 If a business owner would be comfortable owning ten companies, why, asks Buffett, should it be any different for an owner of common stocks? On average, "85 percent of the available diversification is achieved with a fifteen-stock portfolio and increases to 95 percent with a thirty-stock portfolio." 9 Buffett asks us to consider: If the best business you own presents the least financial risk and has the most favorable long-term prospects, why would you put money into your twentieth favorite business rather than add money to the top choices? Reduce Portfolio Turnover Portfolio turnover creates transactions costs, which reduce your total return. For taxable investments, the effects of high turnover are far more damaging. Each time a stock is sold, assuming the transaction results in a profit, you must forgo part of the reward in the form of taxes. Remember, the unrealized capital gain in your portfolio is yours to keep as long as you own the stock. By holding on to the gain, assuming the investment tenets behind owning the company have not changed, you are able to compound your net worth more forcefully. Treat your portfolio as if you were the chief executive officer of a holding company. "A parent company," says Buffett, "that owns a subsidiary with superb long-term economics will not sell the company's 'crown jewel.' Yet this same CEO will impulsively sell stocks in his personal portfolio with little more logic than 'You can't go broke taking a profit.' In our view," explains Buffett, "what makes sense in business also makes sense in stocks: An investor should ordinarily hold a small piece of an outstanding business with the same tenacity that an owner would exhibit if he owned all of that business." 10

Develop Alternative Performance Benchmarks The focus investing approach is an economic-based rather than a pricebased model. In an economic based model, concentrating the portfolio around a few select stocks is emphasized because it allows you to better understand and monitor the businesses you own. In an economic-based model, it is understood that owning fewer stocks, as opposed to more, works to reduce the overall economic risk of the portfolio. Volatility, in an economic-based model, is good because it gives you an opportunity to buy more shares of great businesses at attractive prices. Conversely, in a pricebased model, diversification is broad, ownership is detached, and volatility is perceived negatively. In an economic-based model, you are comforted in the knowledge that future share prices of stocks correlate strongly to the underlying economics of the business. If the economics of the business improve, the share price will likely rise; if the economics of the business deteriorate, the future price of your business can be expected to fall. In this framework, you have a winner's advantage, a method with a high probability of success. The opposite approachtrying to outguess what short-term prices will beis a loser's game. However, just because an economic-based model does not rely on short-term price changes as measures of progress, this does not mean that focus investors are left without a way to gauge their performance. It only means they need to call on a different measuring stick. Focus investors can measure the progress of their portfolio by calculating the look-through earnings, just as Buffett does. To calculate the total earning power of your companies, multiply the earnings per share by the number of shares you own. The goal of the business owner, Buffett explains, is to create a portfolio of companies that, in ten years, will produce the highest level of look-through earnings. Learn to Think in Probabilities We already know that Warren Buffett is passionate about the game of bridge. You will probably not be surprised that he and Charlie Munger see many parallels between the card game and investing. "Our approach to investing," says Charlie, "is the same way you would work out a bridge problem: by evaluating the real probabilities." (OID) 11 Buffett's favorite book on the game is called Why You Lose at Bridge, by S.J. Simon. It contains several insights that focus investors should take note

of. According to Simon, "The card player who takes the trouble to be aware of the mathematical principles involved in his game is the rare exceptionand usually a professional at that. It is not his superior skill that brings him the bulk of his profitsit is his superior mathematical awareness." 12 Any game of cards, whether the game is bridge, poker, or blackjack, is mainly mathematical. So too is investing, but the mathematics of investing, remember, are not out of reach. The algebra involved in a Bayesian inference is high school level. In investing, of course, the exercise of pure math often has to be supplemented with subjective probability analysis, and those skills come from your business experience. Buffett has said, on several occasions, that he is a better investor because he is a businessperson and a better businessperson because he is an investor. "You do see repetition of certain business patterns and business behavior," Buffett points out. "And Wall Street tends to ignore those, incidentally." (OID)13 If you become the sort of investor who focuses on the underlying business patterns, you will find that you are more easily able to think in probabilities, and that will be a tremendous competitive advantage. After all, says Simon, what prevents good bridge players from becoming great bridge players is "mathematical apathy." Recognize the Psychology of Misjudgment Blaise Pascal, one of the fathers of probability theory, said, "The mind of man at one and the same time is both the glory and the shame of the universe." (OID)14
Munger - He

says, "The mind of man has both enormous power as well as standard misfunctions that often cause it to reach wrong conclusions." (OID) 15 It is important to remember that the focus investment approach is not for everyone. It is a unique style that is often at odds with how the majority of people think about investing. "Each person," says Charlie, "has to play the game given his marginal utility considerations and in a way that takes into account his own psychology." According to Charlie, "If losses are going to make you miserableand some losses are inevitableyou might be wise to utilize a very conservative pattern of investment and saving all your life." (OID)16 Buffett would concur. As long as you have a long-term investment horizon, the risk of focus investing, says Buffett, "becomes the risk of you yourselfof whether you're able to retain your belief in the real

fundamentals of the business and not get too concerned about the stock market." (OID)17 Ignore Market Forecasts Buffett says that the stock market is frequently efficient. When it is efficient, information randomly becomes available in the marketplace, and participants quickly work to set prices. But notehe does not say the market is always efficient. From time to time, the prices set by market participants do not accurately reflect a company's intrinsic value. Stock prices disengage from the intrinsic value of a business for various reasons, including psychological overreaction as well as economic misjudgment. Focus investors are perfectly positioned to take advantage of this mispricing. But, to the degree they incorporate macroeconomic or stock market predictions inside their model, focus investors will diminish their competitive advantage. Wait for the Fat Pitch Ty Cobb once said, ''Ted Williams sees more of the ball than any man alivebut he demands a perfect pitch." That intense discipline may explain why Williams is the only .400 hitter in the past seven decades. Warren Buffett is a great admirer of Ted Williams and, on several occasions, has shared Williams's disciplined approach with Berkshire's shareholders. In The Science of Hitting, Williams explained his technique. He divided the strike zone into seventy-seven cells, each representing the size of a baseball. Now, said Buffett, "Swinging only at balls in his 'best' cell, Williams knew, would allow him to hit .400; reaching for the balls in his 'worst' spot, the low outside corner of the strike zone, would reduce him to .230." 18 The investment analogy of Williams's hitting advice is obvious. For Buffett, investing is a series of "business" pitches, and, to achieve aboveaverage performance, he must wait until a business comes across the strike zone in the "best" cell. Buffett believes investors too often swing at bad pitches, and their performance suffers. Perhaps it is not that investors are unable to recognize a good pitcha good businesswhen they see one; maybe the difficulty lies in the fact that investors can't resist swinging the bat. How do we overcome this dilemma? Warren Buffett recommends that investors act as if they owned a "lifetime decision card" with only twenty punches on it. Throughout your life, you get to make only twenty investment choices. Each time you swing the bat, your card is punched and you have one fewer investment available for the remainder of your life.

This would force you to look only for the best investment opportunities. Don't be tempted to swing at the pitches that are low and outside. Williams, waiting for his best pitch, took the risk of striking out. In that regard, investors have it easier, Buffett says. Unlike Williams, "We can't be called out if we resist three pitches that are barely in the strike zone."19 The Responsibility of Focus Investors: Fair Warning Label Do not approach the market unless you are willing to think about stocks, first and always, as part ownership interests in a business. Be prepared to diligently study the businesses you own, as well as the companies you compete against, with the idea that no one will know more about your business or industry than you do. Do not even start a focus portfolio unless you are willing to invest for a minimum of five years. Longer time horizons will make for safer rides. Never leverage your focus portfolio. An unleveraged focus portfolio will help you reach your goals fast enough. Remember, an unexpected margin call on your capital will likely wreck a well-tuned portfolio. Accept the need to acquire the right temperament and personality to drive a focus portfolio. As a focus investor, your goal is to reach a level of understanding about your business that is unmatched on Wall Street. You may protest that this is unrealistic, but, considering what Wall Street promotes, it may not be as hard as you think. If you are willing to work hard at studying businesses, you will likely get to know more about the company you own than the average investor, and that is all you need to gain a competitive advantage. Why Has Wall Street Ignored Focus Investing? Why do people reject ideas? Particularly, we should ask, why are ideas rejected when they appear to work with great success? The person best qualified to answer this question was Thomas Kuhn. Kuhn, who died in 1996, was a physicist turned philosopher. His 1962 masterpiece, The Structure of Scientific Revolutions, is considered one of the most, if not the most, influential philosophical works of the latter half of the twentieth century. The book, which has sold over a million copies, introduced the concept of paradigms and the now-familiar phrase "paradigm shifts." It was Kuhn's contention that progress in science does not always occur smoothly. Although we might think that scientific discovery covery is a

process of adding intellectual bricks to an already sturdy edifice, Kuhn showed that scientific progress sometimes occurs by crisisfirst by tearing down the intellectual fabric of the prevailing model or paradigm, and then by reconstructing a brand new model. History appears to validate Kuhn's theory. The Copernican revolution replaced the idea of earth's centrality, and Einstein's general theory of relativity unseated Euclidean geometry. In each case, before there was a paradigm shift, explained Kuhn, there was first a crisis period. Some people believe that the current intellectual tug-of-war between broadly diversified portfolios and focus portfolios is such a crisis. According to Kuhn, the first step in a paradigm shift occurs when an anomaly is introduced. "I've always found the word 'anomaly' interesting," said Buffett, "because Columbus was an anomaly, I supposeat least for a while. What it means is something the academicians can't explain. And rather than reexamine their theories, they simply discard any evidence of that sort as anomalous." (OID) 22 You might think that, in today's world, scientists readily accept new and even contradictory information and then work collegially to construct a new paradigm. Nothing could be further from the truth, said Kuhn. "Though they [the proponents of the current paradigm] may begin to lose faith and then consider alternatives, they do not renounce the paradigm that has led them into crisis." 23 Having invested so deeply in an education and business that preach the current model, the idea of accepting a paradigm shift is an intellectual, emotional, and financial risk not worth taking. Historically, when paradigm shifts do occur, they stretch over many decades and involve multiple generations, which allows ample time to educate new proponents. When it can no longer be denied that the old paradigm has gone massively astray, there appears on the horizon an unstoppable force of new paradigm proponents. Until the shift is completed, the biggest challenge is how proponents of the new model can survive in a world hostile to their success Investment Versus Speculation Keynes, "Investment is an activity of forecasting the yield on assets over the life of the asset; . . . speculation is the activity of forecasting the psychology of the market."24 Graham, "An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not

meeting this requirement are speculative."25 Buffett believes: "If you're an investor, you're looking at what the assetin our case, businesseswill do. If you're a speculator, you're primarily forecasting on what the price will do independent of the business.'' (OID)26 Generally, they all agree that speculators are obsessed with guessing future prices while investors focus on the underlying asset, knowing that future prices are tied closely to the economic performance of the asset. If they are correct, it would appear that much of the activity that dominates the financial markets today is speculation, not investing. On Learning One thing we know about Charlie is that he "believes in the discipline of mastering the best that other people have figured out. I don't believe in just sitting down and trying to dream it all up yourself. Nobody's that smart." (OID) 29 Buffett would agree. "I've mainly learned by reading myself," he said. "So I don't think I have any original ideas. Certainly, I talk about reading Graham. I've read Phil Fisher. So I've gotten a lot of ideas myself from reading." According to Buffett, "You can learn a lot from other people. In fact, I think if you learn basically from other people, you don't have to get too many new ideas on your own. You can just apply the best of what you see.'' (OID)30 Gaining knowledge is a journey. Warren Buffett and Charlie Munger took much of their wisdom from people who came before them, shaped it into their own mosaic of understanding, and now generously offer it to others that is, to others who are willing to do their own homework and learn all they can, with a fresh, vigorous, open mind. "It's extraordinary how resistant some people are to learning anything," Charlie once said. "What's really astounding," Buffett added, "is how resistant they are even when it's in their self-interest to learn." Then, in a more reflective tone, Buffett continued, "There is just an incredible resistance to thinking or changing. I quoted Bertrand Russell one time, saying, 'Most men would rather die than think. Many have.' And in a financial sense, that's very true." (OID)31

Historical Berkshire Holdings 1988 Capital Cities/ABC Inc GEICO Corp The Coca-Cola Company The Washington Post Company Federal Home Load Mortgage 1989 The Coca-Cola Company Capital Cities/ABC Inc GEICO Corp The Washington Post Company Federal Home Load Mortgage

1990 The Coca-Cola Company Capital Cities/ABC Inc GEICO Corp The Washington Post Company + Wells Fargo & Company Federal Home Load Mortgage

1991 The Coca-Cola Company GEICO Corp The Gillette Co Capital Cities/ABC Inc Federal Home Load Mortgage The Washington Post Company Wells Fargo & Company 1992 The Coca-Cola Company GEICO Corp Capital Cities/ABC Inc The Gillette Co Federal Home Load Mortgage Wells Fargo & Company + General Dynamics The Washington Post Company 1993 The Coca-Cola Company GEICO Corp The Gillette Co

Capital Cities/ABC Inc Wells Fargo & Company Federal Home Load Mortgage The Washington Post Company General Dynamics

1994
The Coca-Cola Company The Gillette Co Capital Cities/ABC Inc GEICO Corp Wells Fargo & Company

+ American Express
Federal Home Load Mortgage The Washington Post Company

+ PNC Bank Corporation + Gannett Co. Inc - General Dynamics 1995 American Express Co
Capital Cities/ABC Inc The Coca-Cola Company Federal Home Load Mortgage GEICO Corp The Gillette Co Wells Fargo & Company - The Washington Post Co

1996 American Express Co

+ The Walt Disney Company

American Express Co
The Coca-Cola Company

The Walt Disney Company + Freddie Mac

+ Travelers Group Inc

Wells Fargo & Company