"An investor should act as though he had a lifetime decision card with just twenty punches on it."
Warren Buffett is venerated with good reason. He has become one of the richest men in the world with what sounds like a simple investing style. The popular formulation of his approach is to buy great stocks at attractive prices and then hold them for the very long term. Patience coupled with the power of compounding will make you very rich.
The logic of this approach is indisputable, but what most investors overlook is that its execution is extremely difficult. If it was as easy as it sounds there would be millions of Warren Buffetts running around. The reality is that there are very few people that have done anything close to what Buffett has done. Many have done well using buy-and-hold investing -- but it is not easy.
So why aren't there more Warren Buffetts?
The biggest obstacle to duplicating the returns of Warren Buffett is stock selection. We like to believe that it isn't that difficult to find great stocks. Just look at Apple, Inc (AAPL) - Get Report , for example. If you bought and held that 20 years ago, you would be well on your way to building a fortune. It is very easy to look back and find hundreds of stocks that have made huge moves over the years.
The problem is that it is so much more difficult to do this on a prospective basis. How simple is it to find those big future winners today? What stock today has the potential to go up like Action Alerts PLUS holding AAPL has over the past 20 years. I personally have no idea -- although I can make some wild guesses and come up with some good arguments.
I'm sure there are many folks that have strong opinions about potential long-term winners, but the market is littered with the remains of stocks that were supposed to be the next Microsoft Corp (MSFT) - Get Report . Wasn't General Electric (GE) - Get Report supposed to be a sure thing to hold for generations? GE is also a holding of Action Alerts PLUS.
Buffett has said "Opportunities come infrequently," and as the quote above states, he feels that there may only be 20 such great opportunities in our lifetime as investors.
That is a remarkable level of selectivity. Just 20 chances to find the big winners, but even if we are that selective, what happens when we concentrate our investment bet in the wrong stock for a very long period of time? Buffett's formula for success -- patience and compounding -- works in reverse, as well. When our selection is bad, our errors carry a hefty price tag.
I contend that for most people, a shorter-term approach is easier and safer, but that requires a rigid methodology to protect capital. Buffett has done so well because he has been able to wait patiently for his ideas to work -- and because his selection has been so good. He has not had many huge mistakes, especially early in his career, to reduce his capital. One or two bad ideas in a buy-and-hold portfolio that is not overly diversified can produce underperformance for many years.
Many investors don't know that Buffett was a very active trader, at times. His investment wisdom may sound very simple and logical, but he is often highly sophisticated in his approach, and is constantly managing risk. He didn't just buy stocks like Coca-Cola Company (KO) - Get Report at an early point and hope they worked out. He has done many other things to manage those positions, such as using the leverage offered by the balance sheets of insurance companies to enhance his returns.
If you are going to try to emulate Warren Buffett, it is imperative that you understand how hard it can be to find one of the 20 great stock opportunities that occur in our investing lifetime. That is a Herculean task, and it is easy to make very costly mistakes during that quest.
(This article originally appeared Nov. 25 on Real Money, our premium site for active traders. Click here to get great columns like this from James "Rev Shark" DePorre, Jim Cramer and other writers.)
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At the time of publication, Rev Shark had no positions in the stocks mentioned.
Action Alerts PLUS, which Cramer co-manages as a charitable trust, is long AAPL and GE.