"All there is to investing is picking good stocks at good times and staying with them as long as they remain good companies." - Warren Buffett
Warren Buffett is widely acknowledged as being the world's most successful investor. Over seven decades, the octogenarian has turned a few thousand dollars into a fortune of $66.6 billion (at the time of writing) by investing in the stock market.
And despite his age, Buffett isn't showing any signs of slowing down just yet.
Unfortunately, most investors will never be able to replicate Buffett's success. The billionaire has had several favorable tailwinds work in his favor over the years. However, the average investor can learn a lot from the way Buffett approaches the market and how he views his potential and existing investments.
A change in strategy
Warren Buffett started his investing career as a value investor, after having studied under the godfather of value investing Benjamin Graham. But Buffett soon became frustrated with Graham's deep value strategy; the strategy was achieving impressive results yet required a lot of work, and on several occasions, Buffett had to take an activist approach to unlocking value. It's at this point that Buffett made the transition to quality and started to follow the mantra "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."
Buffett's decision to switch from value quality marked a turning point in his career. By focusing on high-quality businesses that could run themselves, with high barriers to entry and wide economic moats, Buffett built a low maintenance, highly concentrated portfolio which has remained unchanged for decades. Only a few of Buffett's holdings have been responsible for the majority of his returns.
It is possible to trace the majority of Buffett's wealth and success to just 25 decisions throughout his career. If you're really rigorous, it's feasible to narrow these 25 choices down to just one or two critical decisions. Buffett's acquisition of insurer GEICO after the firm's near miss with bankruptcy, and American Express after the salad oil scandal could be the most significant trades of his career.
Replicating Buffett's strategy
When it comes down to it, every investor can replicate Buffett's strategy with minimal effort and experience. You see, Buffett's strategy only really has two parts to it: 1) buy quality companies at low prices 2) hold these companies forever.
Buying quality companies at low prices is actually the easy part. Indeed, most investors fail when it comes to part two; holding onto equities for decades.
There is plenty of academic research out there, (as well as evidence in the results of billionaires like Warren Buffett) which shows the best returns from equities are only possible to achieve over a multi-decade time horizon. There are several reasons for this. First off, trading in and out of positions can become very expensive, both in taxes and commission costs. Even in today's world of low-cost online stockbrokers trading costs can still add up and eat away at long-term returns. Secondly, long-term investors benefit from the effects of long-term compounding.
Don't underestimate compounding
According to Investopedia, the power of compounding was said to be deemed the eighth wonder of the world - or so the story goes - by Albert Einstein. Compounding is the ability of an asset to generate earnings, which are then reinvested to generate their own earnings. In other words, compounding refers to generating earnings from previous earnings.
And by using the power of compounding, you can accelerate your investment returns without any additional input of either money or time on your part.
Take US tobacco and beer giant Altria (NYSE: MO) for example. Since 1995, shares in Altria have returned 10.2% per annum, outperforming the S&P 500 by 2.7% per annum over the period. If you include reinvested dividends, however, since 1995 shares of Altria have returned 18.5% per annum, compared to a return of 8.3% per annum for the S&P 500. Over the two-decade period, including reinvested dividends Altria's shares have produced a compound return of 3371.5%. Excluding dividends, the compound return is 656.1%.
Similarly, an investment in Warren Buffett's favorite company Coca-Cola (NYSE:KO) has produced a compound return of 337% for investors since 1995 including reinvested dividends. Excluding reinvested dividends Coca-Cola has only returned 258%.
These two examples show how easy it is for wealth to accumulate by just sitting back and letting the power of compounding do its work.
Aside from the impact of compounding and the costs of trading in and out of positions, another reason why the best investment returns are only possible by doing nothing is to do with the futility of trying to time the market.
Trying to time the market by selling in anticipation of a market crash, buying in anticipation of a rally often turns out to be a costly mistake for the investor.
According to DALBAR, the financial research firm, the average US investor realized an average annual return of 3.7% per year vs. the S&P 500's 11.1% over the past 30 years. Over this period of three decades, a $1,000 investment in the S&P would be worth $23,583 today. The average investor's ending balance, however, is just $2,965.
Bad timing has something to do with this underperformance. Too many people try to buy low and sell high but end up selling low and buying high.
If you need more evidence to show how badly the average investor performs, consider this chart from Rich Bernstein, which shows that almost every asset class, barring the Japanese stock market outperformed the average investor on an annualized basis between 31/12/1993 and 31/12/2013.
Buying and holding with a long-term outlook and now attempts to time the market is the only way to avoid falling into the low return trap. The best chart to illustrate this comes from a research report, titled Timeless Wisdom for Creating Long-Term Wealth. The following graph is fairly self-explanatory. It illustrates how the returns of four hypothetical investors were impacted by different reactions to the 70s bear market.
Each invested $10,000 in the market from January 1, 1972, to December 31, 2013, but all four investors acted differently during the 1973 to 1974 bear market.
The Nervous Investor sold out and went to cash. The Market Timer sold out but moved back into stocks on January 1, 1983, at the beginning of a historic bull market. The Buy and Hold Investor held steady throughout the period. And lastly, the Opportunistic Investor realized that the bear market had created opportunities and contributed an additional $10,000 to his original investment on January 1, 1975.
The first step
They say the first step to overcoming any addiction is to acknowledge that you have an addiction in the first place and decide to make a change. Knowing and understanding the above information puts the average investor on the same track, however, in this case, the addiction takes the form of bad investment returns.
By knowing that most investors are saddled with poor returns and they are saddled with these returns because they trade too much, you can start to make changes to your own investment style.
To try and overcome the desire to trade too often, the author of this article adopted an approach suggested by Dr. Daniel Crosby, a renowned psychologist, and behavioral finance expert. Dr. Crosby suggests that investors separate their holdings into various 'buckets' which are focused on particular goals. For example, an investor saving for retirement may have an 'income bucket' or ten high-income stocks that only need to be reviewed on an annual basis. The younger investor may have a bucket of growth stocks, alongside another bucket of income stocks to add a certain element of predictability to the portfolio. The author of this article uses four buckets in his portfolio, a 'core bucket' containing four key holdings making up around 30% of the portfolio, which he intends to hold forever. A 'quality, income and growth bucket' which is made up of around ten holdings or 40% of the portfolio with a long-term outlook. Holdings in this bucket can graduate to the 'core bucket'. A 'value bucket', ten more holdings all of which meet set value criteria and will remain in the bucket as long as they appear overvalued. And finally, a 'speculative bucket' these holdings are both speculative growth and value stocks. Due to the speculative nature of this bucket, there's no set time frame and the whole bucket accounts for less than 10% of the portfolio.
The bottom line
Overall, most investors will never be able to replicate Warren Buffett's success but by learning from his style of investing you should be able to boost your returns. Doing nothing to your portfolio and holding on through thick and thin may seem like a stupid idea at first glance, yet the evidence shows that this strategy works, and it's the only way to achieve market-beating returns.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: This article was written by Rupert Hargreaves for Winvestor Optimizer.