Buffett also observed: "Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of 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 traumatized 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."⁸

Perhaps Buffett's views on market-timing efforts are best summed up by the following from the 2004 Annual Shareholder Letter of Berkshire Hathaway:

Over the 35 years, American business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns: All they had to do was piggyback Corporate America in a diversified, low-expense way. An index fund that they never touched would have done the job. Instead many investors have had experiences ranging from mediocre to disastrous. There have been three primary causes: first, high costs, usually because investors traded excessively or spent far too much on investment management; second, portfolio decisions based on tips and fads rather than on thoughtful, quantified evaluation of businesses; and third, a start-and-stop approach to the market marked by untimely entries (after an advance has been long underway) and exits (after periods of stagnation or decline). Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.

The above observation is perhaps why Buffett has stated that investing is simple, but not easy.⁹ The simple part is that the winning strategy is to act like the lowly postage stamp that adheres to its letter until it reaches its destination. Investors should stick to their asset allocation until they reach their financial goals. The reason it is not easy is that it is difficult for most individuals to control their emotions-emotions of greed and envy in bull markets and fear and panic in bear markets. In fact, bear markets are the mechanism that serves to transfer assets from those with weak stomachs and without investment plans to those with well-thought-out plans-with the anticipation of bear markets built into the plans-and the discipline to adhere to those plans.

Summary

Bear markets are a necessary evil in that their existence is the very reason that the stock market has provided the large risk premium and the high return that investors have had the opportunity to earn. But there is another important point that investors need to understand about bear markets. Investors in the accumulation phase of their investment careers should actually view bear markets not just as a necessary evil, but also as a good thing. The reason is that bear markets provide those investors (at least those that have the discipline to adhere to their plan) with the opportunity to buy stocks at lower prices, increasing expected returns. It is only those that are in the withdrawal phase (e.g., retirees) that should fear bear markets. The reason is that withdrawals make it more difficult to maintain the portfolio's value over the long term. Thus, investors in the withdrawal phase have a lesser ability to take risk and should build that into their plan.

The bottom line for investors is this: If you don't have a plan, immediately sit down and develop one. Make sure the plan anticipates bear markets and outlines what actions you will take when they occur (doing so when you are not under the stress that bear markets create). Put the plan in writing in the form of an investment policy statement and an asset allocation table and sign it. That will increase the odds of your adhering to it when you are tested by the emotions caused by both bull and bear markets. And then be sure to stay the course, altering your plan only if your assumptions about your ability, willingness or need to take risk have changed.

End Notes

1. Morningstar FundInvestor (July 2005).

2. David Dreman, Contrarian Investment Strategies, p.57.

3. Charles Ellis, Investment Policy (Irwin Professional Pub 2nd edition 1992).

4. 1996 Annual Report of Berkshire Hathaway.

5. 1992 Annual Report of Berkshire Hathaway.

6. 1996 Annual Report of Berkshire Hathaway.

7. 1991 Annual Report of Berkshire Hathaway.

8. 2006 Annual Report of Berkshire Hathaway.

9. Financial Analysts Journal, November/December 2005, p. 51.

Larry Swedroe is the author of Wise Investing Made Simple (2007), The Only Guide To A Winning Investment Strategy You Will Ever Need (2005), What Wall Street Doesn't Want You to Know (2000), Rational Investing In Irrational Times, How to Avoid the Costly Mistakes Even Smart People Make Today (2002), and The Successful Investor Today: 14 Simple Truths You Must Know When You Invest (2003), and co-author of The Only Guide to a Winning Bond Strategy You'll Ever Need (2006). He is also a principal and director both of research of Buckingham Asset Management and BAM Advisor Services-a Turnkey Asset Management Provider serving CPA-based Registered Investment Advisor (RIA) practices-in Clayton, Missouri (www.bamservices.com).

His opinions and comments expressed within this column are his own, and may not accurately reflect those of the firm.

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