Edward Quince’s Wisdom Bites: OPV Page 421

At the end of the 1988 Berkshire Hathaway annual meeting Buffett said, “You shouldn’t own common stocks if a 50% decrease in their value in a short period of time would cause you acute distress.”

A company losing 50% of its market value seems insane to most of us, but Buffett reminds us that it is a historical certainty.  Buffett’s own Berkshire Hathaway has seen its stock cut in half on three separate occasions.  More recently a company like Nike is down nearly 50% in the last year and over 70% in the last 5 years. History is littered with iconic companies that have lost at least 50% of their value.  

Further the market as a whole has experienced shocks of greater than 50% at least twice in the last 25 years with the Dot-com bust of 2000-2002 and the Global Financial Crisis of 2007-2009.

It is easy to be lulled into believing that these types of declines won’t happen again or to us - and I hope they don’t - but we need to acknowledge that although history doesn’t repeat, human nature often does.

Buffett is reminding us that volatility is the price of admission to equity investing. Outstanding long-term returns are never free.  Market declines are not punishments, they are the ‘invisible invoice’ you must be willing to pay if you want the chance of seeing amazing compounded returns over a 20 year horizon.

Market volatility, specifically market declines invoice us fees in the form of psychological torture, a form of torture that often urges us to act to make it stop.  Just sell and the pain will be behind you.  Herd instinct makes us want to panic-sell, after all it’s the panic selling that is contributing to the magnitude of the market decline, not panicking is now contrarian and contrarians are lonely.

So if we can’t escape these drawdowns, what can we do?  Perhaps we can look to the advice of Morgan Housel and his philosophy of “save like a pessimist, invest like an optimist.”

The first half of this advice, ‘save like a pessimist’ functions as an antidote to being a forced seller.  If you are able to maintain some cash buffer you don’t have to answer the door when Mr. Market comes knocking. 

The second half of this advice, ‘invest like an optimist’ functions on a belief in the upward trajectory of human innovation and productivity (or perhaps in the future of AI innovation and productivity). It is staying invested so that the exponent (time) in the compounding equation can do the heavy lifting.