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A Guru's Advice

Buffett says he will not invest in a business unless he personally understands it. This advice, coming from someone whose investing track record is the stuff of legend, is something that every investor should follow

Every year, some of those interested in absorbing some unusually astute common sense about business and investing eagerly await the release of Warren Buffett's annual address to his company's shareholders. Buffett is often regarded as the greatest investors in the world. Now I don't know whether such a title can be justified but Buffett is certainly a great investor. However, to those who are not shareholders of Berkshire Hathaway (his company), Buffett's importance is in the way he invests, and in what he says and writes about business, investing and even life.

Buffett is currently worth about US$ 42 billion dollars and is the world's second richest man, one spot behind Bill Gates and a few ahead of Laxmi Mittal in Forbes magazine's 2006 billionaire's list. However, Buffett's approach to life is substantially different from most others on that list, notably from Mittal's. He lives in an unpretentious manner, still in a house that he bought about half a century ago for US$ 31,000. His salary of US$ 100,000 a year is modest by any standards and most remarkably, he has announced that all his personal wealth will go to charity when he dies. And this is not a vague promise-when his wife died two years ago, her entire personal fortune of US$ 2.6 billion (about Rs 11,700 crore) went to charity.

Buffett's annual address to his shareholders and the answers he gives to their questions at Berkshire's annual meetings contain a great deal of common sense that adds up to an uncommon amount of investing wisdom. This year, in response to an investors' question he repeated something he first said during the tech boom, that he does not invest in businesses he does not understand. Think carefully about what the old man is implying. He is saying that even if there is a great investment, he will not invest in it unless he personally understands it.

This advice, coming from someone whose investing track record is the stuff of legend, is something that every investor should follow. Over the last months, people have started buying stocks for amazing reasons. The other day there was this person who told me that he had read a report from some big research firm about the State Bank of India's real estate holdings. The reasoning seemed garbled but boiled down to the level of simplicity that Buffett would like, it was this: raging property prices and the huge DLF hype had convinced him that real estate was the key to massive gains and SBI owns lots of land and therefore this was a reason to buy SBI. Maybe. Who knows, SBI could change all its offices from bank branches to shopping malls or parking lots or whatever else will best convert land to money in the future.

Can money be made from such investments? Yes, it can be if you invest today and quit tomorrow when guy with the next hot story comes along. At that point, of course, you will take your gains and invest in some other hot story and so on and so forth while the quality of stories keeps falling and one day no one believes in these stories any more.

See, the way to measure the amount of money you make in the markets is not how many of these stories made money for you, but by taking the amount you take out of the market and subtracting the amount you brought in. That's the key, the money you actually take out minus the money you brought in.

Otherwise, you'll just end up proving what Buffett once said: The stock market is designed to transfer money from the active to the patient.