The real secret of Warren Buffett’s success

It's no secret that Warren Buffett has an outstanding investment track record.

And if you have much more than a vague interest in investment, you probably think you already know a fair bit about Buffett's approach to buying stocks.

However, some new academic research on Buffett has revealed a hidden ingredient to his success.

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He's actually taken on a good bit more risk - and been a lot less boring' - than many people realise, all in order to juice up his returns.

So what's the secret sauce? And can you use it to help you boost your returns?

Investing the Warren Buffett way

Let's start with a quick recap of the conventional wisdom on Warren Buffett.

The story goes that Buffett has succeeded because he invests for the long-term in companies that are predictable, profitable and not too volatile.

He makes sure that the companies have the financial strength to pay out decent dividends. They also often have low price-to-book ratios (so they're cheap compared to the value of their underlying assets).

It's a sensible, value-orientated approach. Buy dull companies you can understand at low-ish prices.

Buffett is also prepared to stick to his guns when markets appear to be going against him. He's patient, and not easily swayed by the crowd. And he's normally vindicated in the end.

Perhaps the best-known example of this was in 1998-2000. Buffett ignored the mania for internet stocks and saw his performance deteriorate dramatically as a result. If he'd been an ordinary fund manager, he'd probably have succumbed to fear of career risk' and bought in as many did.

But of course, once the dotcom crash happened, Buffett looked very savvy once again.

So that's the conventional wisdom on Buffett. He makes money by being patient, focusing on dull' stocks, and only investing when the conditions are right for him.

The secret ingredient that turbo-charged Buffett's returns

But new research from the National Bureau of Economic Research (NBER) in the US tells us that this picture of Buffett as some sort of buy and hold' Zen master doesn't give us the complete picture.

The first point to note is that once you adjust for the level of risk he takes, Buffett's performance is very good - but it's not super-human.

The Sharpe ratio is often cited as the best way to measure risk-adjusted performance (for more on how the ratio works, you can read my colleague Phil Oakley's piece here.

Buffett's ratio is 0.76, about twice the market average. That's undeniably very good, but there are other investors out there who have beaten him albeit not for such a long period. So if you just look at the Sharpe Ratio, Buffett isn't the greatest investor ever.

Yet if you look at the overall performance of his portfolio at Berkshire Hathaway (NYSE: BRK), his performance has been extraordinary. Between 1976 and 2011, he delivered an average return of 19% a year. That's on top of the return you would have received from a T-bill (a short-term US government bond) over that period.

So how did Buffett manage to soup up his returns? It's not because his investments were in themselves high risk.

Instead, say the NBER researchers, Buffett boosted his performance (and his risk levels) by using leverage. In other words, he borrowed money geared up' - to make larger investments.

How does this work? The only time the average person gears up to invest is when they buy a property. And typically, they don't think of it as gearing up, because they're buying the home to live in. But you can use the example of a mortgage to show how gearing works.

Say you buy a flat for £100,000. You put a £10,000 deposit down, and borrow £90,000 from the bank. Within a year, the price has gone up 10%. You sell the flat for £110,000. Of that, you get £20,000 and £90,000 goes back to the bank.

You had £10,000, now you've got £20,000. So you've doubled your money. A 10% movement in the underlying asset value has given you a 100% return. It works exactly the same for shares (indeed, this is how spread betting works).

So that's part of Buffett's strategy. The underlying stocks might be relatively dull in most cases, but buying them with borrowed money magnifies any movement in the share price greatly.

The trouble with gearing and Buffett's real secret

Of course, the problem with using debt to buy an asset is that it increases your downside risk too. If the property in the above example had fallen by 10%, you'd have lost all your capital.

And unlike buying property, if you've borrowed money to buy stocks and the value of your shares drops, the lender may ask you to stump up a bigger deposit to cover potential losses (this is a margin call'). If you can't do that, or the price keeps falling, you'll end up being forced to sell out at firesale prices and take a huge loss.

That's why gearing is so risky.

So the last thing you should take from this research is that it's time to run out and gear up your portfolio, or to swap your Isa for a spread betting account. There's a good chance it could all go wrong and you could lose large amounts of cash as you pay off your lenders.

What's really key about Buffett's approach is that even although he used leverage to fund some of his investments, he was always able to continue with his investment strategy. He was never forced to sell any of his shares at rock-bottom prices to fund a margin call. He's always been able to hold on until the good times return.

Even when he was using a high-risk tool like leverage, he made sure he had plenty of breathing room. He made sure he would never get into a position where his back was going to be against the wall.

So in fact, the real lesson goes back to one of the key tenets of value investing the approach we all associate with Buffett. When you're planning an investment, always look for a margin of safety'. You need to know what the worst-case scenario is, and how you'll deal with it if it happens.

Buffett's great secret isn't that he uses leverage. It's that he's patient enough to only invest in opportunities where he's confident enough of the downside to make really big bets. When he can't see any decent opportunities out there, he stands aside, rather than fretting about all the money other people seem to be making.

And the good news is that this is one thing you, as a private investor, have in common with Buffett. No one forces you to be in the market. That's a real advantage over the professionals. And if markets are expensive, you should use it.

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