Warren Buffett has gladly shared his perspective on how to make money in the stock market, and he wants us to see there are three simple things we all must do.
The incredible results
In his 2004 letter to Berkshire Hathaway (NYSE:BRK-A)(NYSE:BRK-B) shareholders, Buffett noted, "Over the 35 years [since the 1960s ended], American business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns."
By all accounts, "terrific results" could be considered an understatement, as Buffett noted the average annual growth rate from owning the S&P 500 stood at a staggering 11.2% -- well above the stock market's historical average of 9.1% (from 1871 to 2013) -- meaning the returns over that 35-year period nearly doubled what an investor should expect to see:
So did that mean Americans everywhere were leaping for joy over the incredible run they'd been a part of? Some were, but regrettably far too many weren't, as Buffett went on to note that in order "for investors to earn juicy returns":
All they had to do was piggyback Corporate America in a diversified, low-expense way. An index fund that they never touched would have done the job. Instead many investors have had experiences ranging from mediocre to disastrous.
There were three reasons some investors saw such poor returns, and thankfully Buffett not only noted what they were, but also how to avoid them.
1. High costs
Buffett began by noting the first reason was "High costs, usually because investors traded excessively or spent far too much on investment management."
Of course, in excessive trading, or day trading, there is the tangible up-front cost of each transaction. The Securities and Exchange Commission warns that day traders should "be prepared to suffer severe financial losses," as they "typically suffer severe financial losses in their first months of trading, and many never graduate to profit-making status."
One study conducted by the North American Securities Administrators Association found that "70% of public traders will not only lose, but will almost certainly lose everything they invest."
It's not just day trading that is expensive, but also investment management. Whether using index funds or actual financial advisers, there are always associated costs.
As my Foolish colleague David Hanson noted, thanks to the typical 1% annual fees charged by financial advisers, there is "future investment opportunity you lose every time that financial advisor deducts from your account each quarter. This means tens -- or even hundreds of thousands -- of dollars can vanish over decades.
Meanwhile, index funds will automatically deduct fees known as expense ratios from every dollar you put in them. If two funds deliver the same returns -- let's say 8% -- while one charges 0.05% and the other charges 1.15%, an investor who had their money in the second fund would have 35% less after 40 years, despite supposedly "identical" returns.
So how do we avoid these high costs? Buffett says we must seek low-cost index funds -- he prefers those offered by Vanguard -- and we also must beware of financial advisers who are trying to entice us into day trading and rapid investing. Instead, we should understand the true value of buy-and-hold investment strategies.
2. Don't blindly follow the crowd; instead, do your homework
Next, Buffett wants investors to also see there is great danger in "portfolio decisions based on tips and fads rather than on thoughtful, quantified evaluation of businesses."
Instead of buying a stock simply because a friend of a friend suggested it, or a quick glance at its financials appeared enticing, Buffett says investors should do careful research.
Going along with his first piece of advice, Buffett told investors in 2004: "If you like spending 6-8 hours per week working on investments, do it. If you don't, then dollar-cost average into index funds. This accomplishes diversification across assets and time, two very important things."
3. Never try to time the market
The final thing Buffett warns against is an effort to jump in and out of the stock market, saying that individual investors have far too often been characterized by "a start-and-stop approach to the market marked by untimely entries (after an advance has been long under way) and exits (after periods of stagnation or decline)."
As investment company Invesco revealed, $100,000 parked in the S&P 500 at the end of 1927 would be worth a staggering $8.1 million in 2012, netting a return of nearly 8,000%. But if an investor missed only the 10 best days over that 20,000-day period, that investment would fall by an astonishing 67% to $2.6 million.
While that same investor would certainly end up with more if he or she missed the 10 worst days, the best and the worst days all too often closely follow each other.
Instead of aiming to time stocks, we should patiently invest a set amount each and every month regardless of what the market is doing -- this is exactly what the previously mentioned dollar-cost averaging is -- and trust that great returns will be delivered.
In his 2012 shareholder letter, Buffett said, "Investors should remember that excitement and expenses are their enemies ... The risks of being out of the game are huge compared to the risks of being in it."
The stock market offers great returns and great risks to investors, and we must be keenly aware of both.
Patrick Morris owns shares of Berkshire Hathaway. The Motley Fool recommends Berkshire Hathaway. The Motley Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.