The Warren Buffett Way, + Website, 3rd Edition

Chapter 5

Portfolio Management

THE MATHEMATICS OF INVESTING

Let’s recap: So far we have studied Warren Buffett’s approach to buying a business or selecting stocks (he, of course, considers them the exact same thing). It is an approach built on timeless principles codified into 12 tenets. We have seen how these principles were applied in many Berkshire purchases, including the well-known classic purchase of Coca-Cola and the recent one of IBM. And we have taken the time to understand how the insights from others helped shape his philosophy of investing.

But, as every investor knows, deciding which stocks to buy is only half the story. The other half of the story is managing the portfolio, which, in turn, is a combination of portfolio construction and ongoing management.

When we think about managing our portfolios, we often believe it is a simple process of deciding what to buy, sell, or hold. These decisions are (or should be, if you want to think like Buffett) determined by the margin of safety, which he measures by comparing today’s stock price to its intrinsic value. You buy great businesses when the price is far below that value, hold them when the price is modestly below, and sell them when the price is significantly higher.

However, the margin-of-safety approach, while crucial, is not sufficient in itself. We must also take into account three important portfolio management constructs that Buffett has developed:

1. His way of building a portfolio for long-term growth.

2. His ...