‘Returns dip as motion rises’

Warren Buffett hasn’t got around to writing a book detailing his investment philosophy till date. But, he does outline his investment philosophy in the letters he writes to the shareholders of his company, Berkshire Hathaway, every year. The nuggets of wisdom these letters offer are for investors at large to understand and remember.

In one such letter, for 2005, he wrote, “Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of a genius. But Sir Isaac’s talents didn’t extend to investing: He lost a bundle in the South Sea Bubble, explaining later, “I can calculate the movement of the stars, but not the madness of men.” If he had not been traumatised by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases.”

This is a basic law investors forget as markets keep going up. During a bull run, investors tend to look at the returns in the recent past and assume that future returns will be identical. They mistake probability for certainty and pump in more money into the stock market. And when the market falls, there is great pain.

In the letter for 2000, Buffett wrote, “The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money.

After a heady experience of that kind, normally sensible people drift into behaviour akin to that of Cinderella at the ball. They know that overstaying the festivities… will eventually bring on pumpkins and mice.

But they nevertheless hate to miss a single minute of what is one helluva party… During a bull run, stock markets offer astonishing returns in a short period of time as compared to other investments. This helps in attracting more money into the stock market and so the markets keep going up.

But is this really good for potential investors?

Well, Buffett had already answered this in his 1997 letter. “A short quiz: If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves. But now for the final exam:

If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall… Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.”

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