Understanding the difference between investing and speculating can be the determining factor in whether or not you create wealth over the course of your life. An investor tries to understand the value of an asset, while a speculator tries to guess the price by predicting the behavior of others in the future. When it comes to investing, there is no better model to follow than the principles of the Ben Graham Value Investing System. These principles have become famous because of the incredible amount of wealth created by Warren Buffett and Charlie Munger of Berkshire Hathaway, but don't be fooled into thinking that they can't be used by normal people to create wealth as well. The 4 principles are simple and as follows:
First Principle - Treat an investment or share of stock as a proportional ownership of a business.
Said another way, take the time to understand an asset or a business so you can accurately value it. The value of a business can be determined by a number of factors, including but not limited to: the vision and business plan, the people and their ability to execute on the plan, the ability to create and protect a competitive advantage (widen the moat), as well as the current and expected future cash flows.
Second Principle - Buy at a significant discount to intrinsic value to create a margin of safety.
Simply put, buy at a price that you believe is less than the intrinsic value. The lower the price relative to value, the greater your margin of safety. Since pricing can fluctuate as the emotions of the market swing on the fear/greed pendulum, the Graham value investor patiently waits until the price for an asset that he likes drops below its value.
Third Principle - Make "Mr. Market" your servant rather than your master.
Mr. Market is bipolar in the short term. Some days it is depressed and will offer you a bargain price, and other days it is euphoric and will pay you more than an asset is worth. Understanding these two critical emotions of the market is the key. You can make the market your servant by analyzing the value of an asset, buying when it is depressed and then wait.
Fourth Principle - Be rational, objective and dispassionate.
Rationality is the best antidote to making psychological and emotional errors. Do not try to predict the behavior of others, but do spend time trying to keep your own behavior from getting in the way of sound judgement.
Although the principles above are very simple, even Buffet and Munger will tell you they are not easy. The hardest part is that the principles by design are always contrary to popular belief. Although they are not easy, through application and experience anyone can use these principles to create wealth over time. Instead of wishing for good luck, shoot for good judgement.