The Motley Fool: Avoid the Mistake That Cost Buffett 8 Years of Better Returns (26 July 2008)

Avoid the Mistake That Cost Buffett 8 Years of Better Returns
By Richard Gibbons July 26, 2008

There's one investment strategy you won't read much about on Fool.com, even though many have tried it. In fact, Warren Buffett spent eight years working with it before discarding it as worthless.

What investment strategy is that? Technical analysis.

Invest like a lemming
Technical analysis is the practice of predicting where stocks will trade based on charts of historical pricing and volume information. There's a certain logic to it. Stocks trade based on supply and demand, which is greatly influenced by investors' attitudes about the stock. The charts should reflect those attitudes and might predict where the stock will go.

It's an attractive idea. Wal-Mart (NYSE: WMT) has bounced between $44 and $50 quite a few times in the past three years. Why not buy at the low, and sell at the high? Or look at Monsanto's (NYSE: MON) chart. Clearly, investors love the stock. Its rise from $11 to $115 seems unstoppable. Why not jump aboard and profit?

Technical analysis is a simple yet compelling strategy. You can see why Buffett spent years early in his career trying to master it.

An expensive mistake
But Buffett discovered one small problem. Technical analysis didn't work. He explained, "I realized that technical analysis didn't work when I turned the chart upside down and didn't get a different answer."

After eight years of trying he concluded that it was the wrong way to invest. Then he focused on the teachings of Ben Graham, which stressed business fundamentals, finding a strategy that both made sense and, more important, worked.

Three simple rules
The billionaire discussed that strategy at the 2008 Berkshire Hathaway general meeting. When he was asked how to avoid the crowd mindset, he said he simply followed Graham's three most important lessons:

1. Buy stocks with a margin of safety.
2. A stock is part of a business.
3. The market is there to serve you, not instruct you.

The first lesson usually makes the headlines. It means that you should buy stocks for less than they're worth. But when Buffett talks about the second and third lessons, he's basically admitting that he wasted eight years of his investing life.

Buying a business
After all, thinking about a stock as part of a business is the opposite of what technical analysis is all about. Technical analysis focuses on trading securities. It doesn't matter whether the security is a share of Goldman Sachs (NYSE: GS), with its investment banking, trading and investments, and asset management arms; or whether that security is a derivative promising the delivery of three tons of Italian meatballs. It's all the same because technical analysis doesn't care about the business -- or the fundamentals.

In Graham's second lesson stocks are far more than just pieces of paper or lines on graphs, and to understand them, you need to understand the business. If you're looking at WellPoint (NYSE: WLP), ignore whether the stock has been up three days in a row, and focus instead on how the company is working to address rising medical costs.

Ways to serve man
Similarly, when Buffett says the market isn't there to instruct, he's saying the movements in the market aren't telling you how to invest.

When Netflix (Nasdaq: NFLX) fell below $3 per share in 2002, the market was saying that Wal-Mart and Amazon.com (Nasdaq: AMZN) would eat the lunch of the young upstart.

When McDonald's hit $13 in 2003, the market was announcing that the Big Mac would end up in the Museum of Neat Ideas Gone Wrong beside the tapeworm diet, land wars in Asia, and Paris Hilton's home videos.

But in both cases, the market was wrong.

So, instead of listening to the market, Buffett seeks to take advantage of it. Sometimes, the market will offer to buy a stock for far more than it's actually worth. Other times, it'll offer you the chance to buy shares of a great company for far less than its fair value. An investor who understands the true value of a business will be able to profit when the market offers great companies on sale.

The Foolish bottom line
You can learn from Buffett's error -- don't focus on charts. Instead, understand businesses and seek excellent stocks the market offers at low prices. These days, the market is particularly treacherous. Some stocks that seem cheap will turn out to be very expensive. Others that are simply beaten down by negativity will post amazing returns.

Our Inside Value team is working to take advantage of the situation, and we've identified several stocks we think will post some of those amazing returns. If you're interested in reading about them, click here for a 30-day free trial.

This article was first published June 16, 2008. It has been updated.

Fool contributor Richard Gibbons should not be used as a dessert topping. He owns shares of WellPoint. The Motley Fool owns shares of Berkshire Hathaway. Wal-Mart, Berkshire, and WellPoint are Inside Value recommendations. Amazon, Berkshire, and Netflix are Stock Advisor picks. The Fool's disclosure policy bears an eerie resemblance to Charlie Munger.