Not too long ago, CNN Money posted “The smartest advice I ever got.” The article is really just a list of forty really good pieces of financial advice. In that list, Whitney Tilson described the secret to learning how to invest — the secret of the stock market:

About 12 years ago I was trying to learn more about personal investing. My good friend Bill Ackman, currently a hedge fund manager for Pershing Square Capital Management, told me, “Read all of Warren Buffet’s Berkshire-Hathaway shareholder letters. That’s all you need to know.”

The Berkshire-Hathaway shareholder letters are available as PDFs from Berkshire Hathaway’s website. They date from 1977 and were all written by Warren Buffett. If you aren’t familiar with the ‘Oracle of Omaha,’ the simplest explanation is his net worth: $62 billion. Buffett’s father was a stock broker — comfortable, but not exactly rich.

I can’t recommend enough that you take the time to read these letters. Investing in the stock market seems like black magic, but in addressing his shareholders, Buffett boils down the matter to the principles of sound investing.

One of the reasons that I think Berkshire Hathaway has done so well under Buffett’s leadership is the fact that he can look at investments clearly. As a rule, most investors let their emotions — at least their optimism — affect their decisions. But Buffett can simply state facts and move on. Consider his predictions for insurance (the cornerstone of Berkshire Hathaway’s ability to generate revenue) for 2008:

That party is over. It’s a certainty that insurance-industry profit margins, including ours, will fall significantly in 2008. Prices are down, and exposures inexorably rise. Even if the U.S. has its third consecutive catastrophe-light year, industry profit margins will probably shrink by four percentage points or so. If the winds roar or the earth trembles, results could be far worse.

Personally, my first reaction to the idea that the best part of my investment will soon be facing trouble is to worry. Maybe I should sell. Maybe it won’t be too bad. Maybe I should never have made that investment in the first place.

Maybe I should just calmly consider the situation and look at the numbers. Buffett spends two pages explaining how Berkshire Hathaway becaame so heavily involved in the insurance business — and why it was a good move. He is confident in the company’s overall investments because he has done the research to know not only what makes a good investment, but also what factor affect an investment and how strongly.

Buffett saw the housing bubble coming. Personally, I’m willing to bet that insurance companies are going to have a tough time in the next couple of years, too. That doesn’t mean I’m going to assume that insurance makes for a bad investment. I’ve been listening to Buffett: “If you’re an investor, you’re looking on what the asset is going to do, if you’re a speculator, you’re commonly focusing on what the price of the object is going to do, and that’s not our game.”

Photo