Warren Buffett - Investing is about knowing what you don’t know

Key takeaways at the end

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What counts for most people in investing is not how much they know, but rather how realistically they define what they don't know. An investor needs to do very few things right as long as he or she avoids big mistakes. [...]

Though the mathematical calculations required to evaluate equities are not difficult, an analyst – even one who is experienced and intelligent – can easily go wrong in estimating future [cash flows]. At Berkshire, we attempt to deal with this problem in two ways. 

First, we try to stick to businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change, we're not smart enough to predict future cash flows. Incidentally, that shortcoming doesn't bother us.

Second, and equally important, we insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we're not interested in buying. We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.

1992 Shareholder Letter

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Obviously, we can never precisely predict the timing of cash flows in and out of a business or their exact amount. We try, therefore, to keep our estimates conservative and to focus on industries where business surprises are unlikely to wreak havoc on owners. [...]

2000 Shareholder Letter

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[...] You don’t need to be an expert in order to achieve satisfactory investment returns. But if you aren’t, you must recognize your limitations and follow a course certain to work reasonably well. Keep things simple and don’t swing for the fences. When promised quick profits, respond with a quick “no.”

2013 Shareholder Letter

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If we have a strength, it is in recognizing when we are operating well within our circle of competence and when we are approaching the perimeter. Predicting the long-term economics of companies that operate in fast-changing industries is simply far beyond our perimeter. If others claim predictive skill in those industries – and seem to have their claims validated by the behavior of the stock market – we neither envy nor emulate them. Instead, we just stick with what we understand.

If we stray, we will have done so inadvertently, not because we got restless and substituted hope for rationality. Fortunately, it’s almost certain there will be opportunities from time to time for Berkshire to do well within the circle we’ve staked out.

1999 Shareholder Letter

[Note that this letter is dated March 1, 2000. Nasdaq Composite peaked three weeks later on March 20, before losing ~76% of its value over the following 2.5 years.]

* Bold emphasis added

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Key concepts and takeaways:

• Acknowledge what you don’t or can’t know: Be honest with yourself. Because someone else pretends to understand a particular industry well does not mean you need to jump on the bandwagon frenzy, even if it seems that Mr.Market is giving them right for a while. 

• Be prudent with estimates: Everyone makes mistakes. The key to long-term success is to avoid the big ones. Be conservative with your estimates to create margin of safety. It is difficult to forecast timing and size of cash flows precisely. It is better to be approximately right than precisely wrong.

• Patience pays off: Almost certainly, over time, there will be opportunities coming up in you circle of competence. Don’t feel that you constantly need to do something and pivot to different sectors or to esoteric ideas within your sector. As discussed in another post, Buffett is happy with one good investment idea per year.