By: Dividend Sensei
In the first part on this risk management series I explained why understanding the true nature of risk is important to avoiding costly investment mistakes.
Warren Buffett once said, “Unless you can watch your stock holdings decline by 50% without becoming panic-stricken, you should not be in the stock market”. Now Buffett is famous for his homespun wisdom, and like most of his quotes they need to be understood in the proper context.
In this case what Buffett means is that investors need to be able to remain calm in the face of normal market volatility. Most of the time stocks rise in fact in any given year there is a 74% chance the market will go up. Since 1871 the S&P 500 has generated total returns of 9.1%, or 7% adjusted for inflation. Or to put another way if you invested $1 in 1871, then the purchasing power of that $1 is $19,756 today.
But here’s the trick to understanding the greatest wealth compounding machine ever devised (the stock market). Stocks are ALWAYS climbing a proverbial wall of worry. That means that there has never been a time in which some major concern, such as: ballooning deficits, rising interest rates, geopolitical instability, terrorism, or domestic political scandals, were not giving investors cause for concern.
This is why I’m an ardent student of market history, because as the saying goes, “history doesn’t repeat, but it often rhymes”. Or to put another way you need to know what’s normal and what’s abnormal to prevent the kind of irrational, knee-jerk emotional reactions that cause investors to overtrade and lose money. So here is a quick primer on market history.