Warren Buffett's Secret Weapon You Never Hear About

"When we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever."

- Warren Buffett (1988)

If you want to invest like Warren Buffett, the chairman and CEO of Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) , then there's at least one thing you better be willing to do: Wait. "Lethargy bordering on sloth remains the cornerstone of our investment style," the 83-year-old billionaire wrote in 1990.

The key to Buffett's success is not simply the fact that he identifies outstanding companies. It's also not only because he chooses the most opportune time to invest in them. Indeed, these abilities would be worth little without the temperament to allow time and the law of compounding returns to fully monetize them.

Trading is hazardous to your wealth
"We are just the opposite of those who hurry to sell and book profits when companies perform well but who tenaciously hang on to businesses that disappoint," Buffett wrote in 1990. "Peter Lynch aptly likens such behavior to cutting the flowers and watering the weeds."

Buffett's affinity for long-term investing stems from two observations. The first is that frequent trading in and out of stocks increases transaction costs, both in terms of broker fees and taxes.

Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac's talents didn't extend to investing: He lost a bundle in the South Sea Bubble, explaining later, "I can calculate the movement of the stars, but not the madness of men." If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases.

I trust you won't be surprised to hear that a chorus of academic and practitioner studies on the impacts of short-term investing agrees wholeheartedly.

A leading paper on the topic, titled "Trading Is Hazardous to Your Wealth," found that investors who traded the most between 1991 and 1996 earned an annual return of 11.4% compared to a gain in the broader market of 17.9%. And an annual survey of mutual fund investors suggests that active trading cuts an average investor's long-term returns in roughly half relative to the average market.

The power of compounding returns
The second observation is that the law of compounding returns, left to work its magic, will serve as a catalyst on one's initial ability to identify outstanding companies that are trading for reasonable prices. This is one of the reasons my colleague Morgan Housel believes that time is the individual investor's "last remaining edge on Wall Street."

And here too, the evidence is overwhelming. In the nearly century and a half between 1871 and 2012, an average holding period of one day generated positive returns 52% of the time -- this is based on the inflation-adjusted performance of the S&P 500. Increase the holding period to one year, and the odds of realizing a gain improve to 68%. And by boosting it to 20 years, your chances of realizing a profit reach 100%.

Source: Morgan Housel

It should come as no surprise, in turn, that Berkshire's biggest holdings are also some of its oldest. Buffett first started buying American Express in 1964 following a scandal that caused its stock to drop more than 50% -- though, to be clear, Berkshire's current stake more accurately dates to the early 1990s. His initial position in Coca-Cola was accumulated in 1988. And Wells Fargo, far and away Berkshire's largest position, was initiated the following year.

The point here is that it's not only important to identify great companies at great prices; it's also critical to allow them to reward your judgment with a long string of compounding returns.

Warren Buffett is worried about this new technology, but you should be happy.
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John Maxfield

John is The Motley Fool's senior banking specialist. If you're interested in banking and/or finance, you should follow him on Twitter.

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