Warren Buffett, certainly knows how to make money. In fact, a 2012 University of New York study found that his company, Berkshire Hathaway (NYSE: BRK-B), has the best risk-adjusted returns of any company or mutual fund that is 30-plus years old.
What does Buffett say is one of the most important aspects of successful investing? Well, let's let the Oracle of Omaha speak for himself.
The importance of buy and hold investing
"Inactivity strikes us as intelligent behavior. Neither we nor most business managers would dream of feverishly trading highly profitable subsidiaries because a small move in the Federal Reserve's discount rate was predicted or because some Wall Street pundit had reversed his views on the market."
-- 1996 letter to shareholders
"Lethargy bordering on sloth remains the cornerstone of our investment style: This year we neither bought nor sold a share of five of our six major holdings."
-- 1990 letter to shareholders
"When we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever. 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."
-- 1988 letter to shareholders
So obviously, Buffett is a fan of buy-and-hold investing, (while also willing to admit mistakes) which makes sense, because not only has this method worked for him, but also numerous studies prove it's the superior method of building long-term wealth.
The reason why is the disturbing fact, as pointed out by my Motley Fool colleague John Maxfield, that most people are simply terrible at market timing. It's therefore no surprise that over the past 20 years, the average investor has underperformed the S&P 500 by 4.2% annually.
"Experts" do no better
Then again, most investors are just regular folks who don't have the expertise to follow the markets daily and scour through financial filings. Surely professional money managers, those who've devoted their lives to beating the market, can do better -- right? Actually, no. In fact, it turns out most money managers end up under performing a simple buy-and-hold strategy.
A 2009 study published in the Financial Analysts Journal analyzed 80,000 institutional investment accounts worth $10 trillion. The study found that between 1984 and 2007, the rebalancing decisions made by the greatest minds in the investing industry resulted in a whopping $170.2 billion in lower returns compared to simply buying and holding those same companies, and that didn't even include transaction costs.
Why almost everyone is a terrible investor
What explains these disturbing findings? Partly, it's basic human psychology, which affects even professional money managers.
Human psychology is geared toward negative reactions. This was illustrated by a 2001 study at Florida State University which found that negative events affect us far more powerfully than positive ones because of how our brains are wired. This is especially true when it comes to our finances. For example, according to behavioral finance pioneers Daniel Kahneman and Amos Tversky: "Individuals feel the pain of a dollar loss more than twice as much as the joy of a dollar gain."
How does this explain why most investors under perform the market? Well, this mental wiring could partly explain why we "buy high and sell low."
For example, when markets are soaring, greed and a herd mentality tempt us to jump on the bandwagon, perhaps by investing in wildly overvalued shares of much hyped "mega-growth" stocks. However, since we react twice as strongly to losses as gains, when markets tank investors can be overcome by an almost unstoppable need to sell. Thus we end up doing the exact opposite of the famous Warren Buffett axiom to "be greedy when others are fearful [and] be fearful when others are greedy."
This psychology leads to what YiLi Chien, a senior economist at the St. Louis Federal Reserve, calls "return-chasing behavior." Specifically, Chien is referring to the fact that the average mutual fund investor pulls money out of under-performing mutual funds and puts it into those that have performed the best recently. Such rearview mirror decision making resulted in annual mutual fund returns between 2000 and 2012 that were 36% lower than simply buying and holding.
Buy and hold isn't the holy grail
Buy-and-hold investing is sound financial advice and some of the most successful investors in history have used it to make vast fortunes. However, buy and hold isn't the same as buy and forget. There is a very important reason to sell a stock no matter what the price has done since you bought it.
If the fundamentals of a business deteriorate enough to invalidate your original investment theory you should probably consider selling it. As Buffett says in his 1988 shareholder letter, sometimes you make a mistake and buy a bad company. It's important to be able to admit your mistake and cut your losses to reinvest the cash into higher-quality alternatives.
This can be very hard to do because of the disposition effect, described in a 1985 study published in The Journal of Finance. This effect describes the common occurrence of investors holding onto losers far too long, largely because of an aversion to realizing losses and admitting they were wrong.
Countless studies and no less than an investing master, Warren Buffett, point out that market timing and frequent trading are easy ways for investors to under perform the market in the long term. However, it's important for readers to understand that buy and hold isn't a panacea either. While the importance of investing in quality companies for the long haul can't be overstated, it's also very important to understand the basic psychology that can lead us to make expensive investing mistakes. Without a doubt, understanding and adjusting for the nature of these mistakes can save you a lot of money over time.
Adam Galas has no position in any stocks mentioned. 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.