How did Warren Buffett get his start....

As a youngster, Warren Buffett was always interested in how to make money.

When he was a teenager, he bought some pinball machines. He figured that a good place to put these pinball machines was in barber shops, since kids who were waiting around for a haircut could play some pinball while they waited. He came to an equitable arrangement with the barbers -- they split the profits evenly. Every week, all he had to do was go around to his various pinball machines and collect his money.

As he became a young man with a wife and started a family, he wanted to find security for his family, so his urge to become wealthy increased. He had studied finance under a man named Benjamin Graham. Graham had written the classic textbook "Security Analysis," where he explained a whole new way of evaluating stocks based on identifying and buying undervalued stocks.

The problem with this was that Graham's method blatantly said that the stock market was not an "efficient market." This flew in the face of the theories of the economists of his day, and of today's economists too. It led to a fierce intellectual conflict between these two schools of thought.

Warren Buffett stepped into this maelstrom. To this day he believes that the "efficient market hypothesis" is wrong -- that is, you can find exceptions where the market is NOT efficient. It is WHERE the theory is wrong that Warren Buffet has made all his money.

What is the efficient market hypothesis? It assumes that the stock market is an "efficient market" where there's perfect knowledge of what's going on, and that knowledge is applied in a purely rational way. So any new information should immediately be factored into the stock price.

The efficient market hypothesis says that if a stock is trading at $252 per share, it really is WORTH $252 a share at that time. However, if a few months later it only trades at $6 a share, then at that later time it is really WORTH $6 a share -- EVEN IF THE FUNDAMENTAL ASPECTS OF THE BUSINESS HAVE NOT CHANGED.

Warren Buffett's criticisms of the "efficient market hypothesis" is that people are not fully logical creatures, but they are in fact highly emotional. People do NOT make unemotional calculations of stock prices, but they are in general highly affected by the daily EMOTIONAL effects of the behavior of others in the stock market. If everyone else is buying, people feel more secure to buy as well. But if everyone else is selling, people also have a tendency to want to sell. This is an emotional reaction -- not one always based on logic.

By using this knowledge, Warren Buffett was able to bring a purely logical approach to stock market investing, which takes advantage of the emotional behavior of most others in the stock market. When the stock prices go too low (due to emotional reasons), Buffett will buy. Then, when they shoot up too high (again due to emotional reasons), Buffett will sell. Using this technique, he has almost always made money.

What's happened to this conflict today? The efficient market hypothesis is still dominant among financial and economic circles. Yet, on the other hand, Buffett is (at present valuation) the second richest person in the USA (behind Bill Gates). As long as the efficient market hypothesis still dominates thinking in financial circles, you can make a LOT of money using Warren Buffett's stock market investing techniques.

- Dien Rice