Welcome to The Motley Fool's '5 Steps to Better Investing' series. With some time for reflection between Christmas and New Year, this is a good chance to review the year just gone, and prepare for the 12 months ahead.
In Step 1 we covered, 'You don't have to make it back the way you lose it'.
Once you've disposed of unwanted ballast and taken on fresh supplies, you're ready to set sail.
Step 2: Patience is a virtue
Despite many theories to the contrary, the share market is a moody and irrational beast.
Sometimes the mood impacts the market as a whole, or entire asset classes – we've been through tech and bio-tech booms and busts and we're living through the current mining boom here in Australia.
Other times, investors' views of individual companies can drive a share price to unreasonable highs or lows – occasionally the same company at different times in its history. Microsoft (Nasdaq MSFT) peaked at almost US$60 per share in late 1999, and its diluted earnings per share clocked in at US$0.84, giving it a price/earnings ratio of 71 times.
Fast forward to the end of 2011, and the share price is around US$26, reasonably unchanged since early 2002, yet profits have grown to around $2.69 per share, for a P/E ratio in the single digits!
The Microsoft example neatly illustrates the extreme moods of the market – its unbridled optimism and deep pessimism. Hindsight is always 20/20, but I don't know how anyone could justify paying almost US$60 in 1999, and I think it's pretty likely that today's price undervalues the business by a wide margin.
Investors can benefit from patience in two key areas.
Patience in buying
A company can be a wonderful business, but not necessarily a good investment. The difference is price. There's no precise formula for success – despite what some will tell you – simply because the future is unpredictable. However, if you're paying a high multiple of earnings, there's little margin for error.
A missed opportunity can be a big disappointment, especially if that company goes on to a much higher share price. However, an impatient purchase of an overpriced company can do long term damage to your portfolio.
In investing, waiting for the risk/return scenario to be more firmly in your favour is one success factor we can have almost total control of.
No amount of patience will reward the investor who purchased Microsoft at US$60 in 1999. By getting caught up in the hype of the market, purchasers at that price are still down over 50% twelve years later. Being a patient buyer – and avoiding that fate – is key.
Patience in holding
Okay, so you've found a quality business, with favourable economics and prospects and at a great price. So far, so good.
However, soon after buying the company, the market tanks, taking the company's share price with it. Or, alternatively, the company releases results that disappoint the market, and the shares pay the price. Lastly, maybe you've held the shares for a year, and while they haven't dropped, they haven't increased either.
In any of the above scenarios, an investor can't be blamed for being a little concerned.
It takes a very strong character to look these facts square in the face and ignore them – and that's exactly the character we need to develop. To be clear, if something has happened to make us less comfortable with the company whose shares we hold, we should definitely reassess and be prepared to sell.
However, if all of our reasoning still stands, and we're still equally comfortable with the underlying business, we shouldn't let the market scare us into selling. After all, this is the market that told us Microsoft was worth US$60 in 1999 and Rio Tinto (ASX: RIO) was worth $124 in May 2008, $23 in December 2008 and $70 a year later.
Many fortunes have been made by investors willing to ignore short-term price gyrations in favour of long term share price appreciation.
Investing isn't always easy. However, we have it within our power to make investing simpler or far more difficult. The difference is the amount of effort we put in, and how patient we are prepared to be.
Brokers and the Australian Tax Office are the prime beneficiaries of hyperactive traders – there are many studies demonstrating the deleterious effects of over-trading and tax on our portfolios.
In this age of online brokerage and instant access to real-time share prices, the impetus to do something is stronger than ever. One of the hallmarks of Warren Buffett's investing is his extreme patience. I'll leave the last words to the Oracle of Omaha:
'I've had periods in my life when I've had a bundle of ideas come along, and I've had long dry spells. If I get an idea next week, I'll do something. If not, I won't do a damn thing.'
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Scott Phillips is The Motley Fool's feature columnist. Scott owns shares in Microsoft. The Motley Fool's purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson