There are various pieces of advice from Warren Buffett that could help investors to maximise their return potential. However, there’s one simple tip that could make a vast amount of difference to all investors without requiring any extra effort.
Buffett has only ever invested in companies and sectors that he understands. This has allowed him to leverage the knowledge he has on specific areas in order to improve his overall returns.
Certainly, Buffett has missed out on a number of investing opportunities during his lifetime that could have increased his net worth to an even larger figure. However, by investing only in areas he fully understands, he has undoubtedly avoided losses that have allowed him to generate high returns over the long run.
With the cost of buying and selling shares having fallen significantly over recent decades, it’s now cheaper than ever to build a portfolio of varied companies. While this makes it easier to obtain a high degree of diversification in order to reduce risk, it also means it’s less costly to ‘dabble’ in a wide range of stocks, in terms of commission costs. In other words, many investors will buy companies without undertaking comprehensive research into their operations and future growth prospects.
This could be a dangerous move, since it may mean an investor has failed to ascertain the potential risks a specific stock may present. For example, its business model may be unfavourable, or it could face risks that haven’t been factored into its share price. As such, undertaking research into the company and its industry could avoid potential losses that would harm overall returns.
As well as avoiding risks, investing in companies you understand can lead to improved returns. For example, if an investor determines they will focus on a particular industry and will gain a significant amount of knowledge on how it operates, they may have a competitive advantage over other investors that enables them to select the most attractive companies within the sector. Over time, this may mean they’re able to outperform their peers, as well as the wider stock market.
Clearly, it’s very difficult to be an expert in every industry. Therefore, it may be worth initially utilising tracker funds for the majority of your capital, since they offer exposure to a diverse range of companies. Then, investing a modest proportion of your capital in industries and companies within your sphere of knowledge could provide the opportunity to outperform the index. Over time, your portfolio may gradually become increasingly weighted to direct equities, rather than being invested in a tracker fund.
Diversification is crucial to reduce risk. However, it can lead to investors buying all sorts of companies they don’t fully understand. As such, following Buffett’s advice on only investing in companies that are within your sphere of knowledge could reduce risk and improve your chances of making a million.
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Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.