"Ladies and gentlemen, please fasten your seat belts; the captain has just announced that we will be encountering some unexpected turbulence."
I hate hearing this phrase whenever I am flying, but there is no way an airplane can completely avoid turbulence (unless it is standing still in a hangar). When flying, captains don't choose the route where there will be fewer clouds or less turbulence. Instead, they choose the safest, fastest way to get their passengers where they need to be. This, more often than not, means hitting a bit of unexpected turbulence.
Now, not unlike a flight, any journey you embark on is undoubtedly going to be a bumpy one. And investing in the stock market is not any different.
A lot of people fear stock market crashes and "unexpected" turbulence like we are seeing now. But if your investment plan will only succeed if there is no turbulence at any time, it's probably not a very good plan. If you follow a sound process, you need to embrace the turbulence - which, I believe, is a better option than avoiding it - if you actually want to get somewhere in your investment journey.
Successful investors are not those who tend to avoid all turbulence, crashes, and declines in their stock portfolios. Instead, they are the ones who know that turbulence might come and look forward to it, brace for it and embrace it at the same time.
The Wrong Barometer of Risk
Most investors are led astray in a market crash because they equate falling or volatile stock prices with rising risk.
Some would sell high-quality stocks "before they fall further," while other will keep holding on to low-quality stocks "till they rise again." Such investors need an understanding of what Warren Buffett wrote in his 2014 letter to shareholders:
Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments - far riskier investments - than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.
If you consider the following BSE Sensex data - monthly changes between August 1997 and February 2016 - you will notice that of the 222 months that have passed, the index has been "volatile" for most of them. I am defining volatility here as a "greater than 5%" rise/decline in the Sensex value (yes, sharp rise in stock prices is also volatility). In fact, if I consider the months that most people will associate with turbulence, or when the Sensex fell by over 5%, these constitute more than 20% of the universe.
How to read the chart: Look at the tallest bar. The BSE Sensex has fluctuated between -3.4% and +0.7% in 55 months during the period from August 1997 to February 2016.
So, it hasn't been a clear, trouble-free ride all the way, even if you had held what a lot of people would erroneously call "safe" - an index fund (the Sensex, by the way, has clocked a CAGR of 9.1% since August 1997, or around 18.5 years). Even for investors who have ridden a few 50 or 100-baggers during this period, the journey has been marred with occasional deep turbulence.
Thomas Phelps concluded the first chapter of his book 100 to 1 in the Stock Market with this powerful thought from George F. Baker:
To make money in stocks you must have "the vision to see them, the courage to buy them and the patience to hold them."
Patience, or the ability to keep on with your investment process despite the occasional periods of turbulence or euphoria, is the rarest of the three, but it pays off in the long run.
Buffett wrote in his 2014 letter:
It is true, of course, that owning equities for a day or a week or a year is far riskier (in both nominal and purchasing-power terms) than leaving funds in cash-equivalents. That is relevant to certain investors - say, investment banks - whose viability can be threatened by declines in asset prices and which might be forced to sell securities during depressed markets. Additionally, any party that might have meaningful near-term needs for funds should keep appropriate sums in Treasuries or insured bank deposits.
For the great majority of investors, however, who can - and should - invest with a multi-decade horizon, quotational declines are unimportant. Their focus should remain fixed on attaining significant gains in purchasing power over their investing lifetime. For them, a diversified equity portfolio, bought over time, will prove far less risky than dollar-based securities.
As the old stock market adage goes, "When they raid the house of ill repute, even the piano players, and the cook go to jail." But if they get a good judge, the piano player and the cook will be out in no time.
Every time you are deciding on an investment, the question you must ask yourself isn't "Will my investment go up or down?" - because of course it will. The question you must ask is, "Will the fact that this investment may go up and own bother me enough to do something dumb?"
Howard Marks started his latest memo:
My buddy Sandy was an airline pilot. When asked to describe his job, he always answers, "hours of boredom punctuated by moments of terror." The same can be true for investment managers…
If you are looking to achieve some success in stock market investing, you should be able and willing to face moments of terror like you face good times, and both with equanimity.