The common knowledge around investing in the stock market is that capital compounds. Not a day goes by that we aren’t being bombarded with graphics from the likes of CNBC, telling us how much $10,000 would be worth in 50 years time if one assumes an average annual return of 5% (if you’re interested, it’s $114,674.00). Of course, this sterilised classroom theory does not hold up in reality. Let’s dig into why this is.
Beware the standard talking points
Your wealth will only compound if you do not suffer losses. That is the simple truth. And in order to minimise losses, you have to make sure that you do not buy stocks at inflated valuations. For instance, if you had invested your wealth in the S&P 500 at the pre-crisis peak in late 2007, you would have had to wait for over five years before the market recovered. None of this is to say that you shouldn’t be investing your money - far from it. But I think it’s a good illustration of how dangerous it is to blindly follow the standard talking points.
I recently came across Seth Klarman (Trades, Portfolio)’s 1995 letter to shareholders of his Baupost Group in which he discusses this very idea, and I thought it would be of interest to highlight an especially relevant section.
Everyone knows that everyone knows
It has become common knowledge that stocks will outperform other asset classes. Klarman pointed out that this belief did not become common knowledge until the bull market of the 80s and 90s really took off:
“Dangerous lessons are being learned by many investors. Warren Buffett (Trades, Portfolio) has pointed out that legitimate theories frequently lie at the root of financial excesses; good ideas are simply carried too far. Today, virtually everyone 'knows' that over the long-run, stocks will outperform other investment alternatives. Of course, almost no one thought of this as the market made cyclical lows in 1974 and 1982. So after a record-setting thirteen year bull market, proponents of this viewpoint are ignoring the high price they must now pay to purchase equities”.
Years of rising stock prices had eroded the (excessive) fears that investors had during the bear markets of the 1970s and early 1980s. Once the belief that stocks will always go up became common knowledge, investors became willing to purchase them at any price, reasoning that they would only get more expensive if they did not pull the trigger as soon as possible.
Of course, stocks do not always go up (although it may be beginning to seem that way today!) - they occasionally become cheap very quickly. Unfortunately, this presents its own set of challenges, as Klarman points out:
“Another dangerous notion is that dips in the market always represent buying opportunities. We firmly believe that one of Baupost's biggest risks, and, needless to say, that of other investors, is that we will buy too soon on the way down. Sometimes cheap stocks become a whole lot cheaper; it simply hasn't happened lately. (And when that happens, expensive stocks will fare far worse).
Buying stocks on the way down become difficult, as no one is capable of knowing just how low they will go. The actions of value investors are initially loss-making, as their bargain-priced assets go even lower. It is for this reason that so few people really become successful value investors - it’s one thing to know intellectually that you will initially book a paper loss on your investments, but it’s an entirely different thing to have to deal with that reality emotionally.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Jim Chanos on Tesla
- Warren Buffett: The Deck Is Stacked Against Shareholders When It Comes to Executive Pay
- Howard Marks: The 3 Stages of Any Bull Market
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