Long-Term Investing: How I Learned to Stop Worrying and Ignore Volatility

I will break my comments into three parts:

• First, I’d like to define what I think risk means. The central point is that how you define risk has a lot to do with your time horizon.

• Second, I’ll discuss how you can help avoid catastrophe. Common to all great long-term investment track records is the managers survived in all kinds of environments.

• Finally, I touch on some behavioral issues—or why dealing with the long-term in the face of volatility is emotionally, physically, and psychologically hard. I’ll wrap up with some suggestions on what you can do if you accept my perspectives.

OK. If you have bought in to my comments on risk, catastrophe, and psychology, what should you consider doing?

1. Decide if you can be or should be a long-term investor. There’s nothing sacred about it—you just have to make sure you properly align your thinking, policies, and processes around your time horizon.

2. Don’t overbet. Constantly consider the problem of induction and the deleterious effects of leverage and incentives.

3. Work to reduce stress and maintain perspective. Some documented ways to lower stress include:

a. Exercise

b. Maintain and cultivate social connections (family & friends)

c. Get sleep and maintain a healthy diet

4. Don’t dwell on short-term portfolio moves. Sidestep loss aversion if possible.

5. Remember the story from Abraham Lincoln. He recounted that an Eastern monarch once charged his wise men to invent him a sentence that would be true in all situations. They came back with the words: “And this, too, shall pass away.” As Lincoln said, this phrase “chastens in the hour of pride, and consoles in the depths of affliction.” This too shall pass and long-term investors stand well to gain. 12

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The Sociology of Markets (Mauboussin on Strategy)

The sociology of markets is an important yet largely unexamined issue for financial market participants. By sociology, we mean the role of financial institutions in asset price setting. Traditional finance theory posits that investors directly buy assets in the market, with the relationship between risk and return guiding their decisions. A sociological examination moves beyond this narrow focus and asks whether the rise and fall of financial institutions, and their associated incentives, has an impact on asset prices.

This report has three parts. First, we ask whether financial institutions matter. The theoretical answer is no but the practical answer is yes. Second, we explore three case studies that show how institutions matter. Finally, we consider where we might go from here—that is, where the money flows are, what the incentives look like, and what those two drivers may mean for asset prices.

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Anatomy Of A Market Crash

When markets go sharply south, investors often act shocked and bewildered. Allusions to "perfect storms" and hundred-year floods parade through the financial headlines as if the market gods were acting on a vendetta. The only problem is these market swoons happen a lot more frequently than weather metaphors suggest: Hundred-year floods seem to appear every three to five years. Scorched investors may be perpetually surprised, but periodic crashes are as old as the markets themselves.

While market history tracks when these crashes happen, the trickier question is what causes them. External shocks--events like Sept. 11, or Hurricane Katrina--are a logical suspect. But it turns out external events are rarely the culprit for big market downdrafts. External factors are responsible for less than 20% of the stock market's biggest moves in the past 50 years.

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Interview with Michael J. Mauboussin

This interview was taken before he joined Legg Mason.


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