Warren Buffett: Volatility in the Market

Market Volatility

What should you do?

If you own a farm or an apartment, you do not get a quote on them every day or every week.

The value of a business depends on how much in terms of cash it delivers to its owners between now and judgment day and I don't think it changes in 10% in a 2 months period if you are looking at it as a business.

Anything, I mean, anything can happen in the market; that is why don't borrow money against any securities.  Markets don't have to open tomorrow.  You can have extraordinary events.


You can get some of the instruments that people don't understand very well that has a lot of fire-power.

Volatility of Single Stocks

Volatility of Single Stocks

Individual stocks tend to have highly volatile prices.

The returns you might receive on any single stock may vary wildly.



Best Performing Stocks

If you invest in the right stock, you could make bundles of money.

• For instance, Eaton Vance, an investment-management company, has had the best-performing stock for almost 25 years.  If you had invested $10,000 in 1979 in Eaton Vance, assuming you had reinvested all dividends, your investment would have been worth $10.6 million by December 2004.

Worst Performing Stocks

On the downside, since the returns on stock investments are not guaranteed, you risk losing everything on any given investment.

• There are hundreds of dot-com investments that went bankrupt or are trading for a fraction of their former highs in early 2000.

• Even established, well-known companies such as Enron, WorldCom and Kmart filed for bankruptcy and investors in these companies lost everything.

All Stocks in Between these two Extremes

Between these two extremes is the daily, weekly, monthly and yearly fluctuation of any given company's stock price.

• Most stocks won't double in the coming year, nor will many go to zero.

• But the average difference between the yearly high and low stock prices of the typical stock on the NYSE is nearly 40%.

Stocks that don't perform over Long Time

In addition to being volatile, there is the risk that a single company's stock price may not increase significantly over time. 

• In 1965, you could have purchased General Motors' stock for $50 per share (split adjusted).  By May 2005 (4 decades later), your shares of General Motors would be worth only about $30 each.  Though dividends would have provided some ease to the pain, General Motors' return has been terrible.  
• You would have been better off if you had invested your money in a bank savings account instead of General Motors' stock.

All your Eggs in a Single Basket

Clearly, if you put all of your eggs in a single basket, sometimes that basket may fail, breaking all the eggs.

Other times, that basket will hold the equivalent of a winning lottery ticket.

Temporary Price Fluctuations is to be expected. It is not possible to avoid random short-term market volatility.

Relevance of Temporary Price Fluctuations 

In addition to the probability of permanent loss attached to an investment, there is also the possibility of interim price fluctuations that are unrelated to underlying value. 

Many investors consider price fluctuations to be a significant risk: if the price goes down, the investment is seen as risky regardless of the fundamentals.


But are temporary price fluctuations really a risk?  

-  Not in the way that permanent value impairments are and then only for certain investors in specific situations. 

-  It is, of course, not always easy for investors to distinguish temporary price volatility, related to the short-term forces of supply and demand, from price movements related to business fundamentals.

-  The reality may only become apparent after the fact. 

-  While investors should obviously try to avoid overpaying for investments or buying into businesses that subsequently decline in value due to deteriorating results, it is not possible to avoid random short-term market volatility.

-  Indeed, investors should expect prices to fluctuate and should not invest in securities if they cannot tolerate some volatility. 



If you are buying sound value at a discount, do short-term price fluctuations matter? 

-  In the long run they do not matter much; value will ultimately be reflected in the price of a security.

-  Indeed, ironically, the long-term investment implication of price fluctuations is in the opposite direction from the near-term market impact. 

-  For example, short-term price declines actually enhance the returns of long-term investors.



There are,however, several eventualities in which near-term price fluctuations do matter to investors. 

1. Security holders who need to sell in a hurry are at the mercy of market prices. 

- The trick of successful investors is to sell when they want to, not when they have to.


2.  Near-term security prices also matter to investors in a troubled company. 

-  If a business must raise additional capital in the near term to survive, investors in its securities may have their fate determined, at least in part, by the prevailing market price of the company's stock and bonds.


3. The third reason long-term-oriented investors are interested in short-term price fluctuations is that Mr. Market can create very attractive opportunities to buy and sell. 

-  If you hold cash, you are able to take advantage of such opportunities. 

-  If you are fully invested when the market declines, your portfolio will likely drop in value, depriving you of the benefits arising from the opportunity to buy in at lower levels.

-  This creates an opportunity cost, the necessity to forego future opportunities that arise
.
-  If what you hold is illiquid or unmarketable, the opportunity cost increases further; the illiquidity precludes your switching to better bargains.



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Every investor who owns common stocks must expect to see them fluctuate in value over the years.

Market Fluctuations of the Investor’s Portfolio

Every investor who owns common stocks must expect to see them fluctuate in value over the years. 

The behavior of the DJIA since our last edition was written in 1964 probably reflects pretty well what has happened to the stock portfolio of a conservative investor who limited his stock holdings to those of large, prominent, and conservatively financed corporations.

• The overall value advanced from an average level of about 890 to a high of 995 in 1966 (and 985 again in 1968), fell to 631 in 1970, and made an almost full recovery to 940 in early 1971. 
• (Since the individual issues set their high and low marks at different times, the fluctuations in the Dow Jones group as a whole are less severe than those in the separate components.) 
• We have traced through the price fluctuations of other types of diversified and conservative common-stock portfolios and we find that the overall results are not likely to be markedly different from the above. 
• In general, the shares of second-line companies* fluctuate more widely than the major ones, but this does not necessarily mean that a group of well established but smaller companies will make a poorer showing over a fairly long period. 

In any case the investor may as well resign himself in advance to the probability rather than the mere possibility that most of his holdings will advance, say, 50% or more from their low point and decline the equivalent one-third or more from their high point at various periods in the next five years.†




* Today’s equivalent of what Graham calls “second-line companies” would be any of the thousands of stocks not included in the Standard & Poor’s 500-stock index. A regularly revised list of the 500 stocks in the S & P index is available at www.standardandpoors.com.

† Note carefully what Graham is saying here. It is not just possible, but probable, that most of the stocks you own will gain at least 50% from their lowest price and lose at least 33% from their highest price—regardless of which stocks you own or whether the market as a whole goes up or down. 

• If you can’t live with that—or you think your portfolio is somehow magically exempt from it—then you are not yet entitled to call yourself an investor. 
• (Graham refers to a 33% decline as the “equivalent one-third” because a 50% gain takes a $10 stock to $15. From $15, a 33% loss [or $5 drop] takes it right back to $10, where it started.

Ref:  Intelligent Investor by Benjamin Graham

Market Fluctuations of the Investor's Portfolio

Every investor who owns common stocks must expect to see them fluctuate in value over the years.

The behaviour of the DJIA probably reflects pretty well what has happened to the stock portfolio of a conservative investor who limited his stock holdings to those of large, prominent, and conservatively financed companies.

Since the individual stocks set their high and low marks at different times, the fluctuations in the Dow Jones group as a whole are less severe than those in the separate components.

The price fluctuations of other types of diversified and conservative common-stock portfolios are not likely to be markedly different from the above.

In general, the shares of second-line companies* fluctuate more widely than the major# ones, but this does not necessarily mean that a group of well established but small companies will make a poorer showing over a fairly long period.

( *non index linked stocks, #index linked stocks)

In any case, the investor may as well resign himself in advance to the probability rather than the mere possibility that most of his holdings will advance, say, 50% or more from their low point and decline the equivalent 1/3 (one-third) or more from their high point at various periods in the next 5 years.

A serious investor is not likely to believe that the day-to-day or even month-to-month fluctuations of the stock market make him richer or poorer.

But what about the longer term and wider changes?

Here practical questions present themselves, and the psychological problems are likely to grow complicated.

A substantial rise in the market is at once a legitimate reason for satisfaction and a cause for prudent concern, but it may also bring a strong temptation toward imprudent action.

Your shares have advanced, good! You are richer than you were, good!

• But has the price risen too high, and should you think of selling?
• Or should you kick yourself for not having bought more shares when the level was lower?
• Or - worst thought of all - should you now give way to the bull-market atmosphere, become infected with the enthusiasm, the overconfidence and the greed of the great public (of which, after all, you are a part), and make larger and dangerous commitments?

Presented thus in print, the answer to the last question is a self-evident NO, but even the intelligent investor is likely to need considerable will power to keep from following the crowd.

It is for these reasons of human nature, even more than by calculation of financial gain or loss, that we favour some kind of mechanical method for varying the proportion of bonds to stocks in the investor's portfolio. The chief advantage, perhaps, is that such a formula will give him something to do.

As the market advances, he will from time to time make sales out of his stockholdings, putting the proceeds into bonds; as it declines he will reverse the procedure.

(For today's investor, the ideal strategy for pursuing this formula is rebalancing)

These activities will provide some outlet for his otherwise too-pent-up energies. If he is the right kind of investor he will take added satisfaction from the thought that his operations are exactly opposite from those of the crowd.

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Note carefuly what Graham is saying here.

It is not just possible, but probable, that most of the stocks you own will gain at least 50% from their lowest price and lose at least 33% from their highest price - regardless of which stocks you own or whether the market as a whole goes up or down.

If you can't live with that - or you think your portfolio is somehow magically exempt from it - then you are not yet entitled to call yourself an investor.

(Graham refers to a 33% decline as the "equivalent one-third" because a 50% gain takes a $10 stock to $15, a 33% loss [or $5 drop] takes it right back to $10, where it started.)


Ref: The Intelligent Investor by Benjamin Graham