There are plenty of factors that have helped Warren Buffett (Trades, Portfolio) achieve his performance over the past 60 years. Some of these factors individual investors cannot really copy (such as his ownership of one of the world's largest insurance groups, Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial)), but others can be replicated.
Possibly one of the most straightforward factors to copy for individual investors is the ability to buy and hold securities with a long-term mindset.
Individual investors have much more flexibility when it comes to buying and holding securities. Institutional investors have less flexibility because they have constraints such as having to beat an index every quarter and restrictions on the percentage that a single security is allowed to take up in a portfolio (i.e., concentration).
The advantage of the long term
To explain why this is such a great advantage, I need to dig into what drives equity returns over the long run. As Benjamin Graham's books try and teach investors, owning a stock is the same as owning a piece of a business, and investors should view it as such.
It should not be viewed as a gambling chip in a casino. This is not new advice. Graham first wrote this advice as much as 100 years ago.
Over the long run, and I'm talking about 10 years plus here, equity returns tend to match the returns from the underlying fundamental business. Here's how Charlie Munger (Trades, Portfolio) has explained this principle:
"Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much difference than a 6% return—even if you originally buy it at a huge discount."
Over the long run, underlying fundamental business performance drives equity returns, but in the short term, factors such as valuation and investor sentiment drive the share price.
For example, one could argue that over the past five years, S&P 500 returns have been driven by multiple expansion rather than business performance, especially in the technology sector. Equity returns will decline as valuations moderate, but it is likely that if one takes the past 20 years of returns and the next 10 years, equity returns will match underlying returns on equity on average over a period of 30 years.
This is where Buffett has been able to gain such an edge. Institutional investors just cannot invest with this kind of time horizon. Most funds do not last 20 years, let alone 30. Individual investors generally do not fare much better. I am willing to bet that most individual investors have not even held onto a single stock for five years, let alone 20.
The essential mindset
This kind of long-term mentality is essential if one is to make market matching or even market-beating returns over the long run. Investors need to focus on underlining return on equity and hold securities throughout the market cycle to ride the company's fundamental growth. In the short term, equity returns can be disrupted by factors such as valuation expansion or compression and market sentiment.
However, over the long run, underlying fundamental business performance will drive equity returns. The only way we can take advantage of this is to own a security for as long as a full market cycle takes, even if that is 30 years or more. Without this discipline, all the time and effort spent determining factors such as equity return will be wasted.
In other words, no matter how much research one does, investors will never be able to beat the market if they do not have a long-term time horizon.
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