At the Wing Chun kung fu school my family and I are part of, there is a common saying: “Motion is lotion”. Whenever my muscles, joints, bones and ego are sore after one of our sparring sessions, our Sifu will tell me that some gentle exercise should help. Moving your body, getting blood into the joints, loosening up the muscles, can be healing.
In the world of martial arts, motion can be healing, but in the often tumultuous world of investing, too much motion can be a recipe for diminished returns.
Warren Buffett, in his 2005 annual letter to shareholders, told this story:
“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.”
What does it really mean? And how can we apply it to our investment strategies?
Understanding the Philosophy
Buffett’s philosophy is rooted in the belief that the more times you trade or change your investment positions, the less your returns are likely to be in the long term. This might be counter-intuitive, especially when contrasted with the frenetic pace of modern-day trading, where constant motion and rapid decision-making are often heralded as the path to success. Those of us old enough to have grown up watching Gordon Gekko in Oliver Stone’s “Wall Street” will remember how he quickly traded in and out of stocks based on his secret intel. That and his timeless advice, “if you need a friend, get a dog”.
The Allure of Active Trading
In today’s fast-paced world, active trading can be seductive. The thrill of buying and selling, the adrenaline rush of making quick decisions, and the allure of potential quick profits can be intoxicating. But is this the right approach for long-term success as an investor?
Buffett suggests otherwise. His investment strategy is characterized by patience, discipline, and a long-term vision. He believes in understanding the intrinsic value of a company and holding on to investments for the long haul.
The Impact of Brokerage Costs
One of the reasons that returns may decrease with increased trading is the associated costs. Every time you buy or sell a security, you incur transaction costs, including commissions and fees. These can add up over time and eat into your returns.
Brokerage for a single transaction can start as low as $5 for an app, and be as high as 2.5% of the transaction if you use a full service broker. Five dollars may not seem like much at first glance, but it adds up and we need to learn to think of it in terms of how it impacts our returns.
Take this scenario – let’s say you have $10,000 to invest, you’re buying 10 x $1000 parcels of stock and you’re paying $10 brokerage per transaction. You’ve spent $100 (1%) of your starting capital on brokerage. And let’s say that over the course of the first twelve months, you have to replace one of your positions, on average, once a month. That means you’ll have two transactions every month – one sell and one buy. Over the course of the year, that’s another 22 transactions and $220 in brokerage. Added to your initial brokerage, you’ve spent $320 (3.2%) out of your $10,000 capital on brokerage.
Now, if you’re a very successful investor, you might be able to match the average growth of the market, which is around 10% per year on average. Keep in mind that the vast majority of professional fund managers can’t manage to match the market over the long-term, so perhaps that might be ambitious for an amateur who is just getting started. Let’s say you average a 7% annual return in your first year. But you’ve lost 3.2% on brokerage, so your net return is actually only 3.8%.
You can get better than that by putting your cash into a savings account with far less effort.
Additionally, frequent trading can lead to unfavorable tax consequences, as you have to pay capital gains tax on any profits you take. If you leave that money invested, it can compound over time.
The Power of Patience
Buffett’s philosophy emphasizes the importance of patience in investing. By carefully selecting investments based on fundamental analysis and holding them for extended periods, investors can benefit from the compounding effect of returns.
The Virtue of Value Investing
Buffett’s investment approach, known as value investing, focuses on identifying undervalued companies with strong fundamentals. By investing in these companies and holding onto them, investors can reap the rewards of their growth over time. Of course, that doesn’t mean that you never sell a stock. It means that if you do sell it, you sell it for the right reasons.
Avoiding the Noise
The stock market can be noisy, filled with daily fluctuations, news, and opinions. Much of the investing industry, including the financial media, fintokkers, financial tip sheets, stock brokers and online trading platforms, need to make a lot of noise. Their entire business model is predicated on people trading a lot and often. It’s good for them but not so good for the investors themselves.
By tuning out this noise and focusing on the underlying value of investments, investors can make more rational decisions. This approach aligns with Buffett’s belief in reducing motion to increase returns.
Applying Buffett’s Wisdom
So, how can you apply this wisdom to your investment strategy?
- Understand Your Investments: Take the time to research and understand the companies you’re investing in. Look for intrinsic value and solid fundamentals.
- Embrace Patience: Resist the temptation to trade frequently. Hold onto your investments and allow them to grow over time. Only sell if you have a very solid reason.
- Avoid Emotional Decisions: Don’t let daily market fluctuations drive your investment decisions. Stick to your strategy and avoid reacting impulsively.
- Consider Costs: Be mindful of the costs associated with trading, including fees and taxes. These can erode your returns over time.
Warren Buffett’s insight that “returns decrease as motion increases” is more than just a catchy phrase; it’s a guiding principle that can lead to more thoughtful and successful investing. By embracing a patient, value-driven approach, investors can reduce the “motion” in their portfolio and potentially increase their long-term returns.
In a world where the buzz of active trading often drowns out the voice of reason, Buffett’s wisdom serves as a reminder that sometimes, less is indeed more. In the pursuit of financial success, slowing down and adopting a thoughtful, long-term perspective may be the key to unlocking greater returns.