The academic literature on investing is filled with hundreds of anomalies. My own view is that the greatest anomaly of them all is that while investors idolize Warren Buffett, the “Oracle of Omaha”, so many not only tend to ignore his advice but often do the exact opposite. Consider the following advice he has offered on trying to time the market:
– In his 1991 annual letter to shareholders, Buffett advised: “ We continue to make more money when snoring than when active.” He added: “Our stay-put behavior reflects our view that the stock market serves as a relocation centre at which money is moved from the active to the patient.”
– In his 1996 annual letter to shareholders, he advised: “Inactivity strikes us as intelligent behavior.”
– In his 1998 annual letter to shareholders he advised: “Our favorite holding period is forever.”
– In a June 25, 1999, interview with Business Week, he advised: “Success in investing doesn’t correlate with IQ. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people in trouble investing.”
– In his 2013 annual letter to shareholders, he advised: “Forming macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous because it may blur your vision of the facts that are truly important.”
– In another often-repeated quote, he advised: “A prediction about the direction of the stock market tells you nothing about where stocks are headed, but a whole lot about the person doing the predicting.”
The bear market sparked by the COVID-19 crisis presented investors with a test of the ability to control their temperament, which Buffett advised was the key to successful investing. On February 19, 2020, the S&P 500 closed at 3,386. Just 23 trading days later, on March 23, it closed at 2,237, a drop of 34 percent — the sharpest drawdown in history over such a short period. How did investors fare? Did they control their temperament?
While we don’t know how all investors did, we do know a large percentage failed the test.
One of the biggest problems facing these investors who ignored Buffett’s advice and engaged in panicked selling is what they do next. With yields at historically low levels, most will be unable to achieve their financial goals sitting totally in cash or safe bonds. That means at some point they will have to decide when it’s safe to get back into stocks. It is also important to remember that the problem with market timing is that you have to be right twice—when to get out and when to get back in.
Whenever I have discussions with investors who are tempted by the latest crisis to abandon their well-thought-out plan, I remind them about Buffett’s sage advice.
FOUR LESSONS TO LEARN
First, it’s important to understand that bear markets are a feature of the stock market.
Without them, there would be no risk and therefore no equity risk premium. As investors, we would not like that. If we were to look back at every other market decline, we would see there were investors who thought the only light at the end of the tunnel was from a truck coming the other way. In each instance, it turned out that wasn’t the case. And it likely isn’t the case now, either. In other words, every past decline looks like an opportunity; every current decline feels like risk.
When the stock market is meeting our best expectations, thinking about the market’s inevitable up and down cycles and the benefits of a disciplined approach sounds reasonable, even easy. Yet, when the market goes down, it often feels different, maybe difficult. That is explained by the tug of war between our emotions and our reasoning. Which side wins? French philosopher Blaise Pascal declared: “All of our reasoning ends in surrender to feeling.” One of the most important roles played by financial advisors is to prove Pascal wrong!
That is why it’s important to write down your reasoning in an investment policy statement (IPS), tied to your specific goals. That way, when emotions grow strong and threaten to overrule reason, reason can prevail. Reason can remind us that this current market correction was expected (you just did not know when), and your financial plan is designed with this in mind.
Second, your investment strategy should be based on evidence, data and logic.
Thus, you should not be swayed to change your strategy unless you are convinced the underlying assumptions on which your strategy was based have changed. There is nothing in today’s environment that should lead you to conclude your assumptions no longer hold.
Third, there are always things to worry about.
It’s why, during bull markets, stocks are said to “climb a wall of worry.” Thus, it’s important to remember that while you might be worried about such issues as still-high U.S. equity valuations (the Shiller CAPE 10 is about 29), finding a cure and/or vaccine for COVID-19, the rapidly increasing debt-to-GDP ratio, the rapidly increasing money supply, and the potential of a major trade war with China, you can be certain that the sophisticated institutional investors now accounting for about 90 percent or more of trading volume (and thus setting prices) are also well aware of those issues. Thus, these risks are already incorporated into prices. That means that unless the outcomes are worse than expected, markets should not fall further. Remember, it doesn’t matter whether news is good or bad, only whether it is better or worse than already expected.
Fourth, don’t make the mistake of confusing strategy with outcome.
Fooled by Randomness author Nassim Nicholas Taleb had the following to say on confusing strategy with outcome: “One cannot judge a performance in any given field by the results, but by the costs of the alternative (that is, if history played out in a different way). Such substitute courses of events are called alternative histories. Clearly the quality of a decision cannot be solely judged based on its outcome, but such a point seems to be voiced only by people who fail (those who succeed attribute their success to the quality of their decision).”
Unfortunately, in investing, predicting results is notoriously difficult. Thus, a strategy should be judged in terms of its quality and prudence before, not after, its outcome is known.
Simple, but not easy
Returning to the advice offered by Buffett, he famously stated that investing is simple, but not easy. The simple part is that the winning strategy is to act like the lowly postage stamp that adheres to its envelope until it reaches its destination. Investors should stick to their asset allocation plan, as laid out in their IPS, until they reach their financial goals. This understanding allowed Buffett to ignore all the critics who criticized him for his “outdated” value strategy during the dot-com boom of the late 1990s, when growth stocks far outperformed value stocks. He didn’t abandon his beliefs then (and was rewarded over the next decade when value dramatically outperformed), and I’m confident he hasn’t abandoned them now.
The reason investing is not easy is that it is difficult for most investors to control their emotions — emotions of greed and envy in bull markets and fear and panic in bear markets. In fact, bear markets are the mechanism that serves to transfer assets from those with weaker stomachs and without investment plans to those with stronger stomachs and well-thought-out plans — with the anticipation of bear markets built in — as well as the discipline to adhere to those plans. Are you following Buffett’s advice?