Wednesday, March 7, 2012

Hurrah! The Stock Market Declined Yesterday!

The S&P 500 dropped by -1.5% yesterday, marking the largest one day decline in the market since December 6.

The media is full of explanations for yesterday's swoon, as well as gloomy predictions for the days ahead.

But here's one comment that you probably won't see:

For a long-term investor, yesterday's decline is actually good news.

Or, taking it a step further:  If you're truly investing in stocks to build assets for the future, any market decline should be greeted as an opportunity to buy shares of attractive companies at cheaper prices.

This is a message that Warren Buffett - and his former mentor Benjamin Graham - have preached for years. 

In a article published in Fortune magazine years ago, Buffett discussed his personal love for hamburgers.  When the price of hamburgers declines, he wrote, they sing the Hallelujah chorus in the Buffett household, since it means they will be able indulge in their favorite meal at lower prices.

Buffett argues that investors should think of stocks in the same fashion.  If you're trying to build a portfolio for the future, market declines present opportunities, yet most investors rarely think this way:

 That sort of behavior is especially puzzling when engaged in by pension fund managers, who by all rights should have the longest time horizon of any investors. These managers are not going to need the money in their funds tomorrow, not next year, nor even next decade. So they have total freedom to sit back and relax. Since they are not operating with their own funds, moreover, raw greed should not distort their decisions. They should simply think about what makes the most sense. Yet they behave just like rank amateurs (getting paid, though, as if they had special expertise). 

Last week I argued that it was not impossible to think that the S&P 500 could reach at least 1700 by the end of 2014, or about +30% higher than yesterday's close.  Viewed in this fashion, a true investor should be hoping that we retrace more of the gains achieved so far this year, as it will present an opportunity.

But that's not the way humans are wired. Higher stock prices generate more interest, while market declines draw fear and trepidation.

Ben Graham had a parable in his book The Intelligent Investor that is an excellent way to view market fluctuations:

Imagine that in some private business you own a small share that cost you $1,000.  One of your partners, named Mr. Market, is very obliging indeed.  Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis.  Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them.  Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.

If you are a prudent investor or a sensible businessman, will you let Mr. Market's daily communication determine your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him.  You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from his when his price is low.  But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.

Words to remember when markets are moving lower!