Optimism and Pessimism in the Stock Market

From time to time my friends will ask me about my investments in the stock market when they see headlines about the market.  For example I once had a friend ask me how I felt about stocks losing 2% for the week due to fiscal cliff worries.  If you have read even a few of the investing articles I have written such as The Investor Mindset, then you already know that I think a 2% drop in the stock market means close to nothing. 

The most important thing that I gained from the 2008-2009 market crash during the great recession is a huge risk tolerance…in a good way.  During the span of close to a year in that time, it was not unusual to see a position drop 10% overnight.  In fact, during the course of a month, you could almost expect a drop or rise in any stock of nearly 20%.  The volatility index spiked to around 80 at one point.  This means that the standard deviation for the daily price change in the overall market was around 5%.  Imagine waking up every day for an entire year and expecting a price change of 5% in the S&P 500.  Of course it only spiked to 80 for a brief while, but the point remains that those were very volatile times. 

One thing that high volatility forces an investor like myself to do is focus purely on the long term.  If I bought into Bank of America at $20, I would have seen it drop by nearly 50% in a matter of months back then.  I had to focus on the long term prospects of the company.  In fact, these wild times are something to get excited over!  If stock prices are plummeting, then you have the opportunity to buy them cheap!  I remember one pundit proclaiming that the SP500 below 700 was a generational low and a once in a lifetime opportunity.  It turns out he was right although I cannot remember his name.  Warren Buffett is one of the most successful investors in modern history, and he has described the stock market and price fluctuations beautifully in his letter to shareholders in 1990. 

                “We will be buying businesses – or small parts of businesses, called stocks – year in, year out as long as I live.  Given these intentions, declining prices for business benefits us, and rising prices hurt us.  The most common cause of low prices is pessimism – some times pervasive, some times specific to a company or industry.  We want to do business in such an environment, not because we like pessimism but because we like the prices it produces.  It’s optimism that is the enemy of the rational buyer.”

This is one of my all-time favorite quotes.  The man is a genius, and his ability to explain complicated topics so simply is a gift.  I have tried to explain this very concept to friends and they think I am nuts.  My friend who asked me about the fiscal cliff had a similar reaction.  I told him that I do not know what will happen to taxes or the stock market in the coming months, but I hope there is a decline in the market.  He responded by telling me that doesn’t make sense because I will lose money.  And thus I tried to explain to him Buffett’s idea that lower prices are my friend and higher prices my enemy so long as I am buying stocks for the long term.  In the short term, yes I will experience unrealized losses, but in the long term I will see my wealth increase due to capital gains, dividends, and option premiums. 

Many times I tell people that I cannot predict the future, but I can react intelligently to things that have already happened.  That is what good investing is all about.  Maintain patience and take advantage of irrational price declines in the market.  It is hard to have the confidence to buy into pessimism, but the rewards can be lofty.  Warren Buffett made billions of dollars worth of purchases during 2008-09 when everyone else thought the world was ending.  He is now enjoying huge returns and continues to see dividends roll in every quarter. 

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