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No investing pain, no investing gain

This school of hard knocks is well worthwhile

Warren Buffett is the famous ‘Oracle of Omaha’ – the investor who has managed to compound the value of his company, Berkshire Hathaway (NYSE: BRK-A, BRK-B) by an annualised rate of 19.7% since 1965, trouncing the gain in the S&P 500 of ‘only’ 9.4% per year.

Don’t get me wrong, that 9.4% annualised would have seen your money grow 74-fold – nothing to sneeze at. But doubling that 9.4% (and adding a bit), as Warren Buffett has done, compounds very nicely. How nicely? Try 5,868-fold. Yes, $1,000 invested in the S&P 500 in 1965 would today be worth $74,000. The same $1,000 in Berkshire Hathaway stock would now be worth a cool $5.86 million.

An astonishing record

Fewer investors know the story of Peter Lynch. Lynch ran the Fidelity Magellan Fund between 1977 and 1990, and delivered gains of 29% per annum – turning $10,000 into $270,000 in a little over a decade.

Lynch gave birth to the popular ‘buy what you know’ theory of investing – harnessing the power of your own life experiences to find great investments. Seeing more people wearing a particular brand of clothing, shopping at certain stores or eating at particular restaurants can give you a clue. You might work for a great company, or have some great customers or suppliers that are listed on the share market.

(Some commentators take issue with Lynch’s ‘buy what you know’ approach, but they miss the point. Lynch never said ‘buy whatever you see and don’t look any deeper’, but that’s how his approach is sometimes misrepresented. ‘Buy what you know’ suggests that the starting point for research can be at your local shopping centre or workplace.)

What is success?

Lynch is also well known for another bit of investing wisdom. He wrote:

“In this business, if you’re good, you’re right six times out of 10. You’re never going to be right nine times out of 10.”

That’s an important quote for all investors. Note Lynch didn’t say ‘if you’re average’ or ‘if you’re mediocre’. He said ‘if you’re good’, you’ll have a strike rate of 60%.

Now we all want to be successful,and no-one wants to buy stocks that fail. But Lynch’s maxim lays bare the reality of investing. Of course, we’d rather be right seven or eight times out of 10, but over a long investing career that’s probably unlikely.

It’s a confronting thought – Lynch is suggesting that if you have a portfolio of 20 companies, you’ll likely be wrong about eight of them. Which eight? I wish we knew. By definition, no investor willingly holds companies that they expect will do poorly. But, at least according to Lynch, you probably have about 40% – if you’re good – of your portfolio invested in companies that will disappoint.

Lest you be deterred, though, Lynch’s argument is that the six of 10 you get right, combined with the four you get wrong will still provide a market-beating return.

Are you tough enough?

Here’s the cold, hard truth: If you can’t stomach a success rate that might be as low as 60%, you probably shouldn’t own individual shares. Because investing can be tough.

We’ve had a couple of downgrades at Motley Fool Share Advisor this week. The vast – overwhelming – majority of our members know to roll with the punches. Not because it doesn’t hurt or they don’t care, but because these sorts of volatile price movements (and the occasional loss) are the price of admission to a game that has seen Australian share prices, on average, increase 27-fold since 1983.

Yes, if you’d set up a blind trust in 1983 with instructions to simply reinvest all dividends, you’d have lived through the floating of the dollar, the Accords, the 1987 sharemarket crash, early 1990s recession, the dot.com boom and crash and the GFC. And despite all of those, a $40,000 investment in 1983 would have made you a millionaire today.

No surprises – and strong returns

If our members had followed all of our recommendations, they’d be sitting on an average return that is more than double that of the All Ordinaries over the same time. That’s despite this week’s tumbles in those two companies. Some individual company returns are negative. Two companies have doubled and a third is showing a gain of 99.9%.

Such a distribution of returns is to be expected. Investing, by its very nature, is trying to pay a reasonable price for a future return which is unknown. We try to improve the odds as best we can by making sure we pay a fair price, and doing as much work as we can to estimate what that future could reasonably look like.

Foolish takeaway

Investing isn’t about certainty. It’s not about being right all of the time. Expecting that you – or your advisor – can be perfect is a recipe for disappointment. Equally, taking silly risks on speculative companies is likely to send you to the poor house before it makes you enough to buy a mansion.

Sensible, business-focussed investing is about trying to find the highest-probability outcomes that are available at a reasonable price. And as Peter Lynch said, if you’re right six times out of 10, you’re good. And, judging by the returns of the past 30 years, ‘good’ can be very profitable indeed.

Foolish, dividend loving investors who are looking for Australian investing ideas can click here to request a Motley Fool free report entitled Secure Your Future with 3 Rock-Solid Dividend Stocks.

Scott Phillips is a Motley Fool investment advisor. Scott owns shares in Berkshire Hathaway.

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