At the 2009 Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) shareholder meeting, an attendee asked about living with stock price volatility. Hereâs what Warren Buffett (Trades, Portfolio) said about Wells Fargo (WFC, Financial), which had seen a peak-to-trough decline in its stock price of roughly 75% in the 18 months leading up to March 2009:
âWells Fargo actually ticked below $9 a share at a time when spreads were never better, when depositing flows were never better, when their advantage in relation of costs of funds versus other large banks had never been better. I had a class meeting that day, and it was the only time any of those classes have ever got me to name a stock. But they actually pushed me⌠And I said, if I had to put all my net worth in one stock, that wouldâve been the stock⌠But you have to be prepared. You canât let somebody else get you in a position where you have to sell out your position. Leverage is what causes people trouble in this world. You never want to be in a position where somebody can pull the rug out from under you. And you also never want to be emotionally in a position where you pull the rug out from under yourself.
You donât want to have other people force you to sell and you donât want to let your own fears or emotions to cause you to sell at the wrong time. I mean, why anybody sells Wells Fargo at $9 a share when they owned it at $25 and the business is better off, is one of the strange things about the way markets behave. But people do it. And they get very affected by looking at prices.
If you own a farm, you donât get a price on it every day. You look to the production of corn. You look to the production of soy beans and prices and cost of fertilizer and a few things. And you look to the asset itself to determine whether you made an intelligent investment. You have your expectations about what the asset will produce. But people in stocks tend to look at the price. They let the price tell them how they should feel. Thatâs kind of crazy in our view. We think you should look at the business just like youâd look at the apartment house that you bought or the farm. They let the fact that a quote is available every day turn it into a liability rather than an asset.â
I think this is one of the most interesting parts of investing. When you buy a stock, you are implicitly saying you think you know more than other market participants. They have made an analytical error, presenting you with an opportunity to invest in an undervalued stock. By definition, you are arguing there has been a market inefficiency that youâre capitalizing upon.
But then something happens: The minute the trade clears, you suddenly start to place a lot of value on Mr. Marketâs opinion. If the stock trades higher, itâs confirmation that you were right. And if it trades lower, you quickly begin to question whether you were wrong and should sell. The original premise - that markets periodically exhibit inefficiencies - goes out the window.
Buffett discussed this phenomenon in 1998 during a speech at the University of Florida:
âThat is one of the first things you have to learn about a stock. You buy 100 shares of General Motors (GM, Financial). Now all of a sudden, you have this feeling about GM. It goes down, you may be mad at it. You may say, âWell, if it just goes up for what I paid for it, my life will be wonderful again.â Or if it goes up, you may say how smart you were and how you and GM have this love affair. You have all these feelings. But the stock doesn't know you own it. The stock just sits there; it doesn't care what you paid or the fact that you own it. Any feeling I have about the market is not reciprocated. I mean it is the ultimate cold shoulder.â
As with all behavioral aspects of investing, keeping a level head is easier said than done. As I noted earlier, Wells Fargo shareholders who held the stock into the single digits watched three-quarters of their investment evaporate over the prior 18 months. In addition, they were inundated with endless commentary in the media about the issues faced by banks. While Buffett clearly believed the fundamentals remained quite strong throughout this period, that was little solace to the investor who was looking to Mr. Market for help. If you did not have a solid understanding of Wells Fargoâs financial position and underlying business, itâs not hard to see why an extended period of sustained losses would lead you to be nervous â and maybe even lead you to capitulate.
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Thatâs a real problem. And itâs probably a deal breaker if youâre going to an active investor (at least, if you want to be one with any chance of outperforming the broader market over the long run). If you cannot accept the pain associated with being a contrarian â which means living through periods of sustained underperformance â youâre going to have a tough time in this game. The reality is that most businesses, over a long enough time horizon, will experience this kind of temporary setback.
The only way I know to avoid succumbing to the pressure of this pain is to put yourself in a position to weather the storm. And the way to do that is to understand what you own, size the position appropriately and be patient. Again, thatâs easier said than done. But if you do that, I think you can confidently tell yourself, âYes, I think I am right and Mr. Market is wrong. And the fact that the stock fell 10%, 20%, or even 50% does not change that assessment.â
If you can say that honestly, short-term volatility must be accepted for what it is â noise. The pain and doubt that you will inevitably feel during such periods must be accepted as part of the game. When the financial results and valuation tell you that you are, in fact, correct, you must be able to sit patiently (sometimes for years) and wait for Mr. Market to correct his error.
Conclusion
As Seth Klarman (Trades, Portfolio) noted in his 1996 shareholder letter, this is a balancing act:
âWe regard investing as an arrogant act; an investor who buys is effectively saying that he or she knows more than the seller and the same or more than other prospective buyers. We counter this necessary arrogance (for indeed, a good investor must pull confidently on the trigger) with an offsetting dose of humility, always asking whether we have an apparent advantage over other market participants in any potential investment. If the answer is negative, we do not invest.â
The important point is understanding humility. That does not mean outsourcing your analysis to Mr. Marketâs short-term changes in sentiment; itâs updating your beliefs as new information is presented and being honest with yourself when the investment thesis is showing cracks (as we have all learned at one time or another, mistakes are unavoidable).
When approached with the proper mindset, volatility can be an asset instead of a liability. It presents opportunities to intelligently allocate capital. Putting yourself in a position to hopefully maintain the proper state of mind during stressful times is likely to work well over the long run.
Disclosure: Long Berkshire Hathaway and Wells Fargo.
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