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Warren Buffett's Letter Lays Out Exactly How 'Unsophisticated' Investors Beat Huge Banks. It's Worth Reading Every Word.

"Active trading...can destroy decent returns... Market forecasters will fill your ear but will never fill your wallet."

Warren Buffett, chairman of Berkshire Hathaway Inc., gestures towards attendees taking his photo as part of the Berkshire Hathaway annual shareholder meeting weekend in Omaha, Nebraska, U.S., on Sunday, May 3, 2009. Buffett said all four candidates to replace him as chief investment officer of Berkshire Hathaway failed to beat the 38 percent decline of the Standard & Poor’s 500 Index last year. Photographer: Andrew Harrer/Bloomberg News\n

There's a key passage in the 2014 Berkshire Hathaway letter to shareholders that helps explain the mindset of Warren Buffett, a man who has made staggering amounts of money over his investing lifetime.

Buffett's points in the Saturday letter: volatility is not the same as risk, you should fear dollar-denominated securities more than a stock portfolio and patience is the name of the game — if you try to beat the market, you'll likely fail.

Warren Buffett, chairman of Berkshire Hathaway Inc., gestures towards attendees taking his photo as part of the Berkshire Hathaway annual shareholder meeting weekend in Omaha, Nebraska, U.S., on Sunday, May 3, 2009. Buffett said all four candidates to replace him as chief investment officer of Berkshire Hathaway failed to beat the 38 percent decline of the Standard & Poor’s 500 Index last year. Photographer: Andrew Harrer/Bloomberg News Warren Buffett, chairman of Berkshire Hathaway Inc., gestures towards attendees taking his photo as part of the Berkshire Hathaway annual shareholder meeting weekend in Omaha, Nebraska, U.S., on Sunday, May 3, 2009. Photographer: Andrew Harrer/Bloomberg News

Read Buffett's advice below:

The unconventional, but inescapable, conclusion to be drawn from the past fifty years is that it has been far safer to invest in a diversified collection of American businesses than to invest in securities – Treasuries, for example – whose values have been tied to American currency. That was also true in the preceding half-century, a period including the Great Depression and two world wars. Investors should heed this history. To one degree or another it is almost certain to be repeated during the next century.

[sharequote align="center"]"Volatility is far from synonymous with risk... If the investor...fears price volatility, erroneously viewing it as a measure of risk, he may, ironically, end up doing some very risky things."[/sharequote]

Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.

It is true, of course, that owning equities for a day or a week or a year is far riskier (in both nominal and purchasing-power terms) than leaving funds in cash-equivalents. That is relevant to certain investors – say, investment banks – whose viability can be threatened by declines in asset prices and which might be forced to sell securities during depressed markets. Additionally, any party that might have meaningful near-term needs for funds should keep appropriate sums in Treasuries or insured bank deposits.

[sharequote align="center"]"[A] diversified equity portfolio, bought over time, will prove far less risky than dollar-based securities."[/sharequote]

For the great majority of investors, however, who can – and should – invest with a multi-decade horizon, quotational declines are unimportant. Their focus should remain fixed on attaining significant gains in purchasing power over their investing lifetime. For them, a diversified equity portfolio, bought over time, will prove far less risky than dollar-based securities.

If the investor, instead, fears price volatility, erroneously viewing it as a measure of risk, he may, ironically, end up doing some very risky things. Recall, if you will, the pundits who six years ago bemoaned falling stock prices and advised investing in “safe” Treasury bills or bank certificates of deposit. People who heeded this sermon are now earning a pittance on sums they had previously expected would finance a pleasant retirement. (The S&P 500 was then below 700; now it is about 2,100.) If not for their fear of meaningless price volatility, these investors could have assured themselves of a good income for life by simply buying a very low-cost index fund whose dividends would trend upward over the years and whose principal would grow as well (with many ups and downs, to be sure).

[sharequote align="center"]"Active trading...can destroy decent returns... Market forecasters will fill your ear but will never fill your wallet."[/sharequote]

Investors, of course, can, by their own behavior, make stock ownership highly risky. And many do. Active trading, attempts to “time” market movements, inadequate diversification, the payment of high and unnecessary fees to managers and advisors, and the use of borrowed money can destroy the decent returns that a life-long owner of equities would otherwise enjoy. Indeed, borrowed money has no place in the investor’s tool kit: Anything can happen anytime in markets. And no advisor, economist, or TV commentator – and definitely not Charlie nor I – can tell you when chaos will occur. Market forecasters will fill your ear but will never fill your wallet. The commission of the investment sins listed above is not limited to “the little guy.” Huge institutional investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits tight for decades. A major reason has been fees: Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers.

And that is a fool’s game.

Read the full letter here.

(H/T: Reddit)

This story has been updated.

Follow Zach Noble (@thezachnoble) on Twitter

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