The Business of Value Investing: Six Essential Elements to Buying Companies Like Warren Buffett

Chapter 2. The Only Three Types of Investments You Need to Know

The third-rate mind is only happy when it is thinking with the majority. The second-rate mind is only happy when it is thinking with the minority. The first-rate mind is only happy when it is thinking.

—A. A. Milne

The beauty of investing is that there is enough room for many participants to succeed. In the U.S. markets alone, there are thousands of publicly traded businesses from which to choose. Add in Europe, Latin America, and the Asian markets, and the pool of opportunity is vast.

Yet many investors fail to outperform the average indexes. John Bogle, founder of the Vanguard Group of mutual funds, once observed that nearly 85 percent of active money managers fail to outperform the broad market indexes.^[6] Part of this result can be explained by elementary statistics. With a sample size (market participants) so large, it is impossible for everyone to beat the average. For one, investing is a zero-sum game: Someone is buying what you're selling and selling what you're buying. When someone is realizing a gain, someone is taking a loss somewhere down the line. For every winner there has to be a loser somewhere in the chain. When Tiger Woods wins a golf tournament, he does so at the expense of the entire field.

Stocks Prices Aren't Always Rational

When it comes to stocks, this zero-sum characteristic might not happen immediately. Consider the Internet boom. For years, it seemed that stock prices would only go up. Someone ...