The five elements that determine victory or defeat in military strategy : The five key elements to win in the stock market
"Principle, Weather, Terrain, Commander, and the Law; these five are the factors that determine victory or defeat in military strategy. Those who know them will be victorious; those who do not know them will not be victorious."
(The Art of War : Laying Plans)
The stock market is a place full of both risks and opportunities. You might become wealthy overnight, or you could lose everything just as quickly. Therefore, we must approach stock market investments with seriousness, thoroughly studying and mastering the necessary knowledge before diving in. As Sun Tzu said: "Warfare is the greatest affair of the state, the basis of life and death, the way to survival or extinction—as such it must be thoroughly pondered and analyzed."
By applying Sun Tzu's five critical elements—"Principle, Weather, Terrain, Commander, and the Law"—to stock market investing, we can develop an organized approach to analyzing and formulating investment strategies.
Principle (The Truth of Stock Investment)
Stocks represent ownership in a company and are also known as equity. When you purchase a company's stock, you become a shareholder, holding a certain proportion of ownership in that company. Therefore, buying stocks is essentially purchasing the underlying company they represent, rather than merely trading stocks to earn profits from price differences without understanding the business behind them.
"Shares are not mere pieces of paper. They represent part ownership of a business. So, when contemplating an investment, think like a prospective owner." – Warren Buffett.
To achieve substantial profits in the stock market, like Warren Buffett, the first and foremost condition is to grasp this principle. Once this principle is understood, investors can develop corresponding investment strategies and acquire the relevant knowledge, ensuring they are on the right path. As Buffett wisely put it, "There's no use running if you're on the wrong road." – Warren Buffett.
Weather (Market Environment)
In ancient times, wise generals would skillfully use changes in the weather to devise battle strategies, creating favorable conditions for their armies. In stock market investing, "weather" represents the market environment, which includes factors such as economic conditions, interest rates, and inflation rates that influence whether the market is bullish or bearish. Investors must constantly monitor market changes and use these conditions to create advantageous opportunities for themselves.
Warren Buffett cleverly personifies the market environment as "Mr. Market", an unpredictable and emotional character. Mr. Market is a fictional persona who offers investors prices for buying and selling stocks daily, with his emotions fluctuating wildly. Sometimes he is overly optimistic (during a bull market), willing to pay higher prices for stocks, while other times he is depressed (during a bear market), ready to sell stocks at lower prices.
Buffett uses the concept of "Mr. Market" to emphasize that investors should focus on the intrinsic value of stocks rather than being swayed by market volatility and emotions. He advises investors to think like business owners, considering whether it makes sense to hold a company's stock rather than being influenced by Mr. Market's emotional swings. By understanding Mr. Market's emotional nature, investors can better seize opportunities in the market, such as buying undervalued stocks when Mr. Market is feeling down and considering selling when he is overly enthusiastic.
This concept underscores the principles of value investing—focusing on fundamentals and long-term value instead of being driven by the market's short-term emotions. "Mr. Market is kind of a drunken psycho. Some days he gets very enthused, some days he gets very depressed. And when he gets really enthused you sell to him, and if he gets depressed, you buy from him." – Warren Buffett.
Terrain (Company Analysis)
In ancient warfare, skilled generals understood the importance of terrain. They knew which landscapes to seize, which offered strategic advantages, which were unsuitable for battle, and which to avoid altogether. In stock market investing, "Terrain" represents the companies in which you invest. Similar to analyzing terrain in The Art of War, you should thoroughly understand the internal workings of the companies that you invest in. This includes assessing their financial health, competitive advantages, and management teams. Such analysis will help you identify which companies have the potential to be valuable investments and which ones you should steer clear of.
Warren Buffett emphasizes that the key to investing is not merely assessing how an industry will impact society or how much it will grow. Instead, it is about determining the competitive advantage of a particular company and, more importantly, the durability of that advantage.
Commander (The Investor Themselves)
In this context, "Commander" represents the investor. Investors must honestly evaluate their risk tolerance, level of knowledge, and emotional control. To succeed in the stock market, you need to ensure that you have the mindset to handle market fluctuations, possess the necessary knowledge and wisdom for stock investing, and have the discipline to stick to your investment strategy.
Warren Buffett believes that successful investors must have good emotional management, invest rationally, and implement their strategies without being swayed by the market's short-term emotions. "The key to success is emotional stability." – Warren Buffett
Buffett also emphasizes that investors should learn and master the analysis of company financial statements. These statements are a set of documents and reports used to record and present a company's financial condition. They provide key information about the company's economic activities and health, helping investors, analysts, shareholders, and regulators understand the company's financial performance. "Unless you are willing to put in the effort to learn accounting, learn how to read and interpret financial statements, else you really shouldn't select stocks yourself." – Warren Buffett
Buffett believes that investors should develop disciplined habits, enabling them to adhere to their investment strategies and avoid being swayed by short-term gains. "We don't have to be smarter than the rest. We have to be more disciplined than the rest." – Warren Buffett
Law (Risk Management and Rules)
In this context, "Law" refers to the rules and risk management strategies in investing. Investors should establish clear investment rules, including buying and selling strategies, position management, and regular portfolio reviews. These practices help reduce risk and protect your investments.
Risk Management:
One of Warren Buffett’s most famous risk management principles is the concept of "Margin of Safety". According to this theory, investors should only purchase stocks they believe are priced below their intrinsic value. This margin acts as a buffer, protecting the investor’s capital even if the market price drops. The margin of safety serves as a risk cushion, helping to preserve an investor’s wealth. To apply this principle, investors must reasonably estimate a stock’s intrinsic value. This typically involves thorough research into the company’s financial statements, performance, and industry outlook to determine the stock’s true worth. "The three most important words in investing: Margin of Safety." – Warren Buffett
Position Management:
Buffett’s approach to managing his investment positions involves concentrating and managing the various stocks and assets in his portfolio. His strategy has two main components: concentrated investing and long-term holding.
Concentrated Investing: Buffett's strategy of concentrated investing means he places the majority of his investments in a few select stocks that he believes have the most potential. Unlike broad diversification, he focuses on a small number of companies that he thinks have strong competitive advantages and future potential. This approach allows him to gain deeper insights into the companies he invests in, simplifying investment decisions and better seizing opportunities. "Wide diversification is only required when investors do not understand what they are doing." – Warren Buffett
Long-Term Holding: Buffett’s investment philosophy emphasizes long-term holding. He typically holds onto stocks for many years, even decades, or sometimes forever. This long-term approach allows him to benefit from the company’s growth over time and reduces the costs and risks associated with frequent trading. He views investing as buying a piece of a business, rather than merely speculating on short-term market fluctuations. "What we really want to do is buy businesses that we would be happy to own forever." – Warren Buffett
The core idea behind Buffett’s position management strategy is that concentrated investing allows him to focus on a few companies he is confident have strong competitive advantages, which he can thoroughly understand. Long-term holding enables him to fully realize the potential of these investments and benefit from time and compounding effects.
By applying these five elements—Principle, Weather, Terrain, Commander, and the Law—to stock market investing, you, as an investor, can develop a more organized and comprehensive investment plan, improve the quality of your investment decisions, and better manage market fluctuations.
