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Stepan Lavrouk
Stepan Lavrouk
Articles (420) 

Warren Buffett: Areas Don’t Make Opportunities, Brains Do

If you want opportunities, don’t forget to use your brain

December 09, 2019 | About:

Almost every day I see an article proclaiming that some new form of investment will lead investors to the promised land. Whether it’s private equity or venture capital today, or dotcom stocks in the 1990s, or the "Nifty Fifty" of the 1960s and 1970s, every era seems to have its own "golden child." Alas, things are rarely so easy.

I bring this up because I was struck by something that Warren Buffett (Trades, Portfolio) said at the Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) annual shareholder meeting in 2007: “Areas don’t make opportunities, brains make opportunities”.

The context for this statement was that a shareholder asked what he thought of managed futures funds; that is, mutual funds which offer investors exposure to the futures and other derivatives markets. Typically, these types of funds promise their investors the impressive results that highly volatile future markets can generate, although they tend to downplay the equally impressive losses that they can inflict.

As you might expect, both Buffett and Charlie Munger (Trades, Portfolio) expressed skepticism at the idea that these funds could consistently beat the market over the long term. However, they did not justify this skepticism on the basis that the funds were too risky, though I imagine they would agree with that idea too. Their justification was that it is a mistake to anoint any "area" of the market as a holy grail for investors. In other words, there is no type of investment vehicle that will outperform the market simply by virtue of being structured in a particular way.

Hedge funds and private equity funds are often marketed to investors as being superior investment vehicles that are destined to earn larger-than-average returns. However, you should remember that nothing in life (or investing) is ever that straightforward. If it were easy, everyone would do it. As Buffett said, "It is a mistake to get sold something on the basis that ‘here is a great area of opportunity’”.

Another form that the "great area of opportunity" argument takes is when financial commentators begin to argue in favour of a particular sector. This happened in the late -90s during the dotcom bubble, when companies with no clients or profits were bid up simply because investors were duped into believing that any internet-related business was destined for greatness. A similar phenomenon - albeit on a much smaller scale - has been happening in cannabis stocks as investors misinterpret broadening legalization as a signal to buy anything related to the industry.

In all of these cases, shareholders of these companies assume the promise of the new area justifies any asking price. In reality, there is no business so good that it can’t be too expensive, and blindly following whatever the latest investing fad is will likely lead to financial ruin. Good investing requires independent and critical thinking, which is what Buffett was getting at in his remarks. Remember that the next time you see an enticing sales pitch, and don’t forget to use your brain.

Disclosure: The author owns no stocks mentioned.

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About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

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