I came across an extraordinary paper from Davis Advisors called The Wisdom of Great Investors. The paper is basically a collection of wisdom from some of the greatest long-term investors in history. Since the paper is relatively long, I thought I’d share with you some of the most important lessons from it.
During extreme periods for the market, investors often make decisions that can undermine their ability to build long-term wealth.
This is something that I’ve seen throughout my whole career and that is about as prevalent at this current moment in time, as in any other market cycle. Currently, markets are euphoric, and it appears just about all anyone wants to talk about is the stock market. Market participants are ratcheting up their risk exposures in year-9 of a bull market, with stocks at the highest valuations in a century, except for maybe the tech bubble in 2000. Market pundits seems to all agree that the next 6-12 months should be good for stocks. Following the herd blindly is how market participants get creamed in stocks. Buffett says it best with, “You pay a high price for a cheery consensus.” If today isn’t a cheery consensus, then what is?
One of the biggest mistakes market participants make is chasing the hot fund and leaving the lagging fund based on short-term performance. The table above shows that from 1994 to 2013, the average stock fund returned 8.7% annually, while the average stock fund investor earned only 5%. This was due to that toxic psychology, which basically ensures that one is selling undervalued stocks to buy overvalued stocks. Focus on long-term performance and understand the strategy you are in. There are times when value outperforms and there are times when the market is led by momentum stocks. The cycles shift, and you don’t want to try to time or chase these momentum shifts.
Understand that Crises are Inevitable
The table above really speaks for itself. There is almost always something to fear in markets geopolitically or economically. It is essential to focus on the things that we can control, such as only buying deeply undervalued securities, and making sure that you have a proper asset allocation. Recognize that historically, periods of low returns for stocks have been followed by periods of higher returns.
After a major bear market, people get discouraged and tend to get out of stocks. Remember all the gold commercials that you saw after 2008? Also, expensive and low-returning products such as annuities become hot commodities for these discouraged market participants. This is where being a value investor is so helpful. When stocks are cheap, and the short-term outlook might be worrisome, the long-term opportunity is usually extraordinary.
Now in 2018, we need to flip this on its head. Stocks are incredibly expensive. The short-term economic outlook looks good, but the long-term outlook on stocks is as bad as it has been since 2000. Just like people are mistaken to be scared to invest when markets have recently plummeted, its is just as a big of a mistake to aggressively be buying index or mutual funds at current prices. Unfortunately, that is what nearly everyone seems to be doing. As the cycle reverses, this psychology will likely lead to the market overshooting on the downside. Don’t let emotions guide your investment decisions! If you weren’t heavily into stocks in 2009, why would you be in 2018, when the market is so much more expensive?
Understand that short-term underperformance is inevitable.
One of the chief reasons most money managers underperform the indexes over the long-term is because they try to mirror the indexes. Unlike the money managers, there aren’t fees on the indexes, so any fund should underperform when they try to do that. Money managers try to mirror the indices so that they don’t get fired by their clients and company. If the market is up, the clients probably did okay. If the market is down, they struggled but so did the index. The best long-term investors are willing to ignore the crowd and focus on the long-term. They understand that short-term underperformance is inevitable. It doesn’t matter if you are Warren Buffett, Peter Lynch, or Benjamin Graham. Once you take away the false hope that you are going to outperform each quarter or year, you will be far happier and far more successful as an investor. There is a time arbitrage that savvy investors can profit from because market participants are scared to buy something with a weak short-term outlook, even if the long-term future looks much brighter. By buying these stocks with short-term issues but great long-term fundamentals, investors can achieve outsized long-term returns. (Think our positions in bond insurance companies currently, or banks after the Financial Crisis.)
In conclusion, I’d like to share a great quote by Shelby Davis; “You make most of your money in a bear market, you just don’t realize it at the time.
This is a very powerful statement. When everyone is pessimistic, we can buy securities at huge discounts to intrinsic value, offering massive upside for us to profit from. Conversely, when markets are euphoric, it is usually best to eschew the consensus and focus on either staying in cash, or finding the deeply undervalued opportunities that are out of favor due to a weak short-term outlook. This is the strategy that we are taking and that I believe will be very fruitful for us. Below is a link to the full article, which I’d recommend reading if you have time. Please feel free to give me a call directly if you need anything at all!