(Yahoo!Finance) - Warren Buffett published his annual letter to Berkshire Hathaway shareholders on Saturday. You can read it here.
Arguably the greatest investor of all time, Buffett is known for timeless insights about investing using very approachable language.
Lately, I’ve been thinking about something he said in his 2005 letter:
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.
Newton was a pretty smart guy. Much of what we’re taught in high school physics and calculus can be tracked back to him. And apparently, he had a pretty good track record as a diversified, buy-and-hold an investor. That was before he got crushed speculating on shorter term swings in the stock market.
When markets make sharp moves up or down for whatever reason, it can be very tempting to stray from your long-term investment plan and ramp up your short-term trading activity in an attempt to maximize gains and minimize losses.
While there may be some opportunities you are able to correctly exploit, there’s also the very high risk that you mistime the market and do significant irreversible damage to your long-term returns. (Read more here and here.)
With every trade comes not one, but two decisions. If you decide to buy, then you also have to know under what conditions you would decide to sell.
Similarly, if you’re thinking about trimming your exposure to stocks because you think the market will go lower in the short-term, then you also have to consider under what conditions you would buy to get back to your target long-term asset allocation. As I wrote in my Thursday newsletter this is “particularly important, because you have to consider scenarios under which prices only rise from“ the moment you sell.
These are all good questions to ask upfront as you formulate your investment plan. Perhaps the most important element of prudent investing is having a good plan.
By the way, Newton’s folly was not that he got involved in the South Sea Bubble. Rather, it’s the fact that he was trading in and out of it. From WSJ columnist Jason Zweig:
Prof. Odlyzko estimates that if Newton had bought and held his South Sea shares continuously from early 1712 through 1723, when the stock stabilized after the bursting of the bubble, he would have earned a cumulative total return of approximately 116%. That’s about 6.5% annually, not counting dividends — a generous return at a time when long-term government bonds carried interest rates of 4% to 5%. However, Newton didn’t buy and hold continuously.
If only Newton had given it time.
By Sam Ro · Contributor
