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Warren Buffett's assumptions in the stock market - how he reduces it's "casino"-like aspects....
Hi Simon,
One thing you are very good at doing is asking questions that make people think! You said, "...If you try to 'reason' statistically, the odds of succeeding in business and stock market on the one hand and the odds of succeeding in casinos are the same." I actually think the "odds" are probably not the same.... I think on average, in the stock market you will tend to make money, whereas in a casino you will tend to lose money. For example, let's say you invest in the stocks that make up the Dow Jones Industrial Averages Index. In July 1936, the DJIA was 164.90. In July 2003, the DJIA was 9233.80. When you calculate it, that means that if you invested in the DJIA during this time, you got an "average" return per year of 6.19%. (It's not a lot, but you'd still be making money.) On the other hand, let's say you spend your money in a casino. To take an example, let's say you're playing American roulette. With roulette, the odds are that for every $38 you spend, you will on *average* (over many spins) lose $2. That means that with each spin, you are on average losing 5.26% with every spin. On average, you are losing money, not gaining it. (You can read more about roulette odds here - http://www.gambling-hall-online.com/roulette/roulette_odds.htm ) Therefore, it seems to me that odds of succeeding are not the same.... In the casino, on average you will lose money. In the stock market (at least with the example of the DJIA), on average (over many years) you will make some money. There's a lot more to answer your question though, as a full answer of your question would have to be a discussion of what causes the price of a particular stock. Clearly there are a lot of factors which cause the price of a stock - how much the company is making in profits (or losses), the expectations of future profits (or losses), macroscopic factors (the general economy, currency exchange rates, interest rates), political events in the world, and so on. It's clearly very complicated. What Warren Buffett seems to assume is that in the *long term*, the primary factor which creates the price of a stock are the net profits the company makes. He thinks that this factor is far more important in the long term than all the other factors. Buffett then chooses stocks in specific companies which have qualities which make their future profits easier to predict with confidence. He chooses companies which have strong monopolies or which are "strong franchises" - which means it is difficult for other companies to jump in and compete with them. These companies are also generally less strongly affected by the various "macroscopic" factors too.... By doing this, Buffett can make "safer" investments in the stock market than many others. As I've mentioned before, in general I try to follow these kinds of assumptions too in my own investments. If these assumptions are correct, then that means that at least for some stocks, future profits can be "predicted" with at least a degree of accuracy. From there, it's a matter of calculating what the company (and hence the stock) is "worth". If the current price is far below what it's "worth" according to these calculations, then it is "undervalued" and could be a good buy. Well, there's a quick answer anyhow.... :) - Dien |
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