When heightened economic uncertainty triggers volatility in the financial markets, it’s easy to think the worst is yet to come. In the stock market (^GSPC), the natural emotional response is to panic and sell before the selling gets worse, especially when the market is already near an all-time high.
Unfortunately, this instinct to sell is driven by behavioral biases that have been proven to consistently lose money for investors. In reality, markets tend to overreact to bad news. And it’s during these times that successful investors make money.
“Prices fluctuate more than values — so therein lies opportunity,” Gotham Capital’s Joel Greenblatt once said. “Why do the prices fluctuate so widely when values can’t possibly? I will tell you the answer I have come up with: The answer is I don’t know and I don’t care. We could waste a lot of time about psychology but it always happens and it continues to happen. I just want to take advantage of it.”
Greenblatt’s value-oriented strategy reportedly earned him an annualized return of 40% from 1985 to 2006.
This type of thinking is very much applicable to investors in the broad indexes.
In its new quarterly guide to the markets, JPMorgan Asset Management shared a couple of interesting charts putting big market sell-offs into context.
This first one shows the largest market drops from peak to trough in any given year since 1980. The average drop is 14.2% during a period when annual returns ended up being positive in 27 of 36 years.
This next chart annotates the S&P 500 in the current bull market. As you can see, there have been numerous times when the selling got scary. But the market managed to come back.
Another legendary investor who thought like Greenblatt was Peter Lynch, the long-time manager of Fidelity’s Magellan Fund.
“A price drop in a good stock is only a tragedy if you sell at that price and never buy more,” Lynch once said via CLSA’s Damian Kestel. “To me, a price drop is an opportunity to load up on bargains from among your worst performers and your laggards that show promise. If you can’t convince yourself ‘When I’m down 25%, I’m a buyer’ and banish forever the fatal thought ‘When I’m down 25%, I’m a seller,’ then you’ll never make a decent profit in stocks.”
In a video tweeted by Charlie Munger watcher Tren Griffin, Munger effectively saw Lynch’s 25% and raised the stakes to 50%.
“If you’re not willing to react with equanimity to a market price decline of 50% two or three times a century, you’re not fit to be a common shareholder and you deserve the mediocre results you’re going to get,” Munger said.
Speaking of centuries, this next chart goes all the way back to 1900. As you can see, there were many events that seemed hopeless. And yet in the long-run, they all proved to be buying opportunities.
“In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president,” Warren Buffett noted in a 2008 NY Times op-ed. “Yet the Dow rose from 66 to 11,497.”
Sam Ro is managing editor at Yahoo Finance.