Greed, When Others Are Fearful, Is Good

Buffett’s Detractors

Warren Buffett has had his share of detractors since his New York Times Op-Ed piece in which he announced he would be buying American stocks in his personal account. According to Buffett, “…fears regarding the long-term prosperity of the nation’s many sound companies make no sense… But most major companies will be setting new profit records 5, 10 and 20 years from now.”  

The crux of the detracting argument is Buffett’s call is untimely, he is too rich to worry about asset allocation or time horizons and you, we are not him. Dianne Francis of Canada’s National Post sums up this viewpoint:

…guys like Warren Buffett also operate in a parallel universe of Cash-Rich, Long-Term, Value Investing. He’s making big bets on American stocks. We should not for lots of reasons. He's just plain wrong and I wrote about that yesterday. The stock markets are not capable of being a valid pricing mechanism for anyone for some time. Besides that every day brings more bad news, and new developments.

Seems to me the detractors have cherry-picked certain lines from Buffett’s piece. Buffett in no way suggested the near term picture would be pretty. In the near term, markets are likely to continue their record breaking volatility and investors may suffer yet more losses. Buffett wrote:

• “In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary.”
• “To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions.”
• “…businesses will indeed suffer earnings hiccups, as they always have.”
• “Let me be clear on one point: I can’t predict the short-term movements of the stock market.”

But Buffett’s qualifying statements are beside the point. His overall point was clearly missed or ignored - due to the widespread fear in the marketplace, stocks of strong businesses are cheap. And, in the long term, these businesses are likely to grow through economic booms and busts. Since, in the long term, stock prices are highly correlative to the performance of businesses, it makes sense to buy when the prices of stocks are below the value of the underlying businesses. That time, according to Buffett, is now.

The Typical Investor Buys High and Sells Low

Buffett goes on to point out the resiliency of the market. He also emphasizes most investors’ uncanny ability to miss out on those gains because of their tendency to buy when they are comfortable (at market tops) and sell when they are fearful (at market bottoms). To underscore Buffett’s point, consider the following:

Research conducted by DALBAR, Inc shows for the 20-year period ending December 31, 2007, the typical mutual fund investor failed to capture the returns of the market. Although the average mutual fund trailed the market by about 2.5%, during this 20-year period, the typical mutual fund investor received a return of 4.48% while the market returned 11.82%. In fact, the investors’ returns were barely above the rate of inflation which clocked in at 3.04% during the period. 

 

The disappointing results received by equity investors are totally due to the manic depressive buying and selling described by Buffett. As the chart below demonstrates, investors sell their mutual fund shares [demonstrated by the downward blue bars] just when market performance deteriorates [demonstrated by the orange line in negative territory].
 

When Ms. Francis suggests the market is a “valid pricing mechanism” she demonstrates, as do her fellow Buffett detractors, she does not understand that price and value are not the same. In the short term, stocks markets are never valid pricing mechanisms. Investors who believe otherwise allow their emotions to dictate their investment timing, a sure way to diminish investment results as the chart/table above demonstrate.

Investors Make Easy Things Difficult

Buffett has given the world one of his golden rules to investing: Be greedy when others are fearful and fearful when others are greedy. In fact, one might say this is the definition of value investing. However, as Buffett noted in his 1984 essay “The Superinvestors of Graham-and-Doddsville” there are not likely to be many converts to the practice. He writes:

Adding many converts to the value approach will perforce narrow the spreads between price and value. I can only tell you that the secret has been out for 50 years [now over 75 years], ever since Ben Graham and David Dodd wrote Security Analysis, yet I have seen no trend toward value investing in the 35 years I have practiced it. There seems some perverse human characteristic that likes to make easy things difficult… There will continue to be discrepancies between price and value in the marketplace, and those who read their Graham and Dodd will continue to prosper.

I’ll be re-reading my Graham and Dodd.

Disclosure: none.

Comments

[Buffett Jr:]

Totally agree with everything you wrote and nice graphs. I'm sure some will come on and post how everything has changed and we are entering a depression. To them I'll sell to you at the next top.

2008 Oct 29 08:27 AM

[carey_jim:]

I remain an agnostic about our economic future, meaning that I see many convincing arguments for continued American prosperity and many convincing arguments for a nasty and long American recession.

However, head-in-the ground optimism OR pessimism is simply an admission that we don't really have a good grasp of the facts.

We need to unearth all the relevant facts of the situation, look at all the economic solutions and theories and move forward from there. If we can come to no certain conclusions, we should admit it.

Looking to the past and expecting more of the same isn't historically wise. I wonder what all those old, "retired" communists in Russia are thinking when they cash their tiny retirement checks. They put all their trust in the infallibility of Soviet Communism and now that they are old, they have no way to repair the damage. Paper soup anyone?

2008 Oct 30 12:32 PM

[FWallace:]

What I've learned over my 25 years of stock market investing is that it appears the bulls and bears work within 5 year cycles, looking back over the past 20 years (S&P 500/charts) beyond the 1987 market crash...

Approximately every 5 years or so the market rises and turns and it falls... (because of a variety of reasons), and from what I've observed this cycle hasn't changed just different circumstances... therefore if disiplined investors followed the wave of the 5 year cycle, how can you go wrong???

1988 - 1994 Bear Market (get out of long stock positions)
1995 - 2000 Bull Market (invest in long stocks)
2001 - 2003 Bear Market (get out of long stock positions)
2003 - 2008 Bull Market (invest in long stocks)
2008 - ? Bear Market (how long will this downdraft last?)

2008 Oct 31 09:31 AM

[FWallace:]

S&P 500 - peaks around 1400 and up.......sell high.

S&P 500 - bottoms between 8000-4000.....buy low.

Revolving cycles???

2008 Oct 31 09:54 AM

[FWallace:]

correction... (from above post)

S&P 500 - peaks around 14000 and up.....sell high.

2008 Oct 31 09:58 AM