Every investor who owns common stocks must expect to see them fluctuate in value over the years.

Market Fluctuations of the Investor’s Portfolio

Every investor who owns common stocks must expect to see them fluctuate in value over the years. 

The behavior of the DJIA since our last edition was written in 1964 probably reflects pretty well what has happened to the stock portfolio of a conservative investor who limited his stock holdings to those of large, prominent, and conservatively financed corporations.

• The overall value advanced from an average level of about 890 to a high of 995 in 1966 (and 985 again in 1968), fell to 631 in 1970, and made an almost full recovery to 940 in early 1971. 
• (Since the individual issues set their high and low marks at different times, the fluctuations in the Dow Jones group as a whole are less severe than those in the separate components.) 
• We have traced through the price fluctuations of other types of diversified and conservative common-stock portfolios and we find that the overall results are not likely to be markedly different from the above. 
• In general, the shares of second-line companies* fluctuate more widely than the major ones, but this does not necessarily mean that a group of well established but smaller companies will make a poorer showing over a fairly long period. 

In any case the investor may as well resign himself in advance to the probability rather than the mere possibility that most of his holdings will advance, say, 50% or more from their low point and decline the equivalent one-third or more from their high point at various periods in the next five years.†




* Today’s equivalent of what Graham calls “second-line companies” would be any of the thousands of stocks not included in the Standard & Poor’s 500-stock index. A regularly revised list of the 500 stocks in the S & P index is available at www.standardandpoors.com.

† Note carefully what Graham is saying here. It is not just possible, but probable, that most of the stocks you own will gain at least 50% from their lowest price and lose at least 33% from their highest price—regardless of which stocks you own or whether the market as a whole goes up or down. 

• If you can’t live with that—or you think your portfolio is somehow magically exempt from it—then you are not yet entitled to call yourself an investor. 
• (Graham refers to a 33% decline as the “equivalent one-third” because a 50% gain takes a $10 stock to $15. From $15, a 33% loss [or $5 drop] takes it right back to $10, where it started.

Ref:  Intelligent Investor by Benjamin Graham

Volatility is not risk. Risk is the reasoned probability of that investment causing it's owner a loss of purchasing power over his contemplated holding period.

Investing is often described as the process of laying out money now in the expectation of receiving more money in the future.

At Berkshire we take a more demanding approach, defining investing as

•  the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power – after taxes have been paid on nominal gains – in the future. 
• More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date.

From our definition there flows an important corollary: The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability – the reasoned probability – of that investment causing its owner a loss of purchasing-power over his contemplated holding period. 

• Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. 
• And as we will see, a non-fluctuating asset can be laden with risk.

Investment possibilities are both many and varied.



http://www.berkshirehathaway.com/letters/2011ltr.pdf

Buffett: In my early days I, too, rejoiced when the market rose. Now, low prices became my friend.

Buffett highlights the irrational reaction of many investors to changes in stock prices.


Today, IBM has 1.16 billion shares outstanding, of which we own about 63.9 million or 5.5%.  Naturally, what happens to the company’s earnings over the next five years is of enormous importance to us.  Beyond that, the company will likely spend $50 billion or so in those years to repurchase shares. Our quiz for the day: What should a long-term shareholder, such as Berkshire, cheer for during that period?

I won’t keep you in suspense. We should wish for IBM’s stock price to languish throughout the five years.

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The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter:

• Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. 
• These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day’s supply.

Charlie and I don’t expect to win many of you over to our way of thinking – we’ve observed enough human behavior to know the futility of that – but we do want you to be aware of our personal calculus. And here
a confession is in order: In my early days I, too, rejoiced when the market rose. Then I read Chapter Eight of Ben Graham’s The Intelligent Investor, the chapter dealing with how investors should view fluctuations in stock prices. Immediately the scales fell from my eyes, and low prices became my friend. Picking up that book was one of the luckiest moments in my life.

In the end, the success of our IBM investment will be determined primarily by its future earnings. But an important secondary factor will be how many shares the company purchases with the substantial sums it is likely to devote to this activity. And if repurchases ever reduce the IBM shares outstanding to 63.9 million,  I will abandon my famed frugality and give Berkshire employees a paid holiday. 

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When Berkshire buys stock in a company that is repurchasing shares, we hope for two events:

• First, we have the normal hope that earnings of the business will increase at a good clip for a long time to come; and 
• second, we also hope that the stock underperforms in the market for a long time as well. A corollary to this second point: “Talking our book” about a stock we own – were that to be effective – would actually be harmful to Berkshire, not helpful as commentators customarily assume.

http://www.berkshirehathaway.com/letters/2011ltr.pdf

Intrinsic Business Value - Look for the long term growth in the intrinsic values of your invested businesses.

Intrinsic Business Value


Charlie and I measure our performance by the rate of gain in Berkshire’s per-share intrinsic business value. If our gain over time outstrips the performance of the S&P 500, we have earned our paychecks. If it doesn’t, we are overpaid at any price.

We have no way to pinpoint intrinsic value. But we do have a useful, though considerably understated, proxy for it: per-share book value. This yardstick is meaningless at most companies. At Berkshire, however, book value very roughly tracks business values. That’s because the amount by which Berkshire’s intrinsic value exceeds book value does not swing wildly from year to year, though it increases in most years. Over time, the divergence will likely become ever more substantial in absolute terms, remaining reasonably steady, however, on a percentage basis as both the numerator and denominator of the business-value/book-value equation increase.

Comment:  It is not easy to determine intrinsic value.  The best PROXY for intrinsic value of Berkshire Hathaway is its book value.  Though this closely tracks the intrinsic value of Berkshire Hathaway,  it actually understates the intrinsic value of the company.  Nevertheless, Buffett opines that using book value to denote intrinsic value is meaningless for most other companies.


We’ve regularly emphasized that our book-value performance is almost certain to outpace the S&P 500 in a bad year for the stock market and just as certainly will fall short in a strong up-year. The test is how we do over time. Last year’s annual report included a table laying out results for the 42 five-year periods since we took over at Berkshire in 1965 (i.e., 1965-69, 1966-70, etc.). All showed our book value beating the S&P, and our string held for 2007-11. It will almost certainly snap, though, if the S&P 500 should put together a five-year winning streak (which it may well be on its way to doing as I write this)

Comment:  Psychological forces trump the fundamental forces in the short term.  In the long term, the fundamental forces always trump the psychological forces that affect the stock price of a company.  Buffett looks at long term performances.  He highlighted that in any given 5 year period, the percentage gains in book value of Berkshire Hathaway have beaten those offered by the S&P 500.

http://www.berkshirehathaway.com/letters/2011ltr.pdf

If you are buying sound value at a discount, do short-term price fluctuations matter?

In the long run, they do not matter much; value will ultimately be reflected in the price of a security.  

• Indeed, ironically, the long-term investment implication of price fluctuations is in the opposite direction from the near-term market impact.  
• For example, short-term price declines actually enhance the returns of long-term investors.  

There are, however several eventualities in which near-term price fluctuations do matter to investors. 

1.  Security holders who need to sell in a hurry are at the mercy of market prices.  The trick of successful investors is to sell when they want to, not when they have to.  Investors who may need to sell should not own marketable securities other than U.S. Treasury bills.

2.  Near-term security prices also matter to investors in a troubled company.  If a business must raise additional capital in the near term to survive, investors in its securities may have their fate determined, at least in part, by the prevailing market price of the company's stock and bonds.

3.  The third reason long-term-oriented investors are interested in short-term price fluctuations is that Mr. Market can create very attractive opportunities to buy and sell.

• If you hold cash, you are able to take advantage of such opportunities.  If you are fully invested when the market declines, your portfolio will likely drop in value, depriving you of the benefits arising from the opportunity to buy in at lower levels.  This creates an opportunity cost, the necessity to forego future opportunities that arise.  
• If what you hold is illiquid or unmarketable, the opportunity cost increases further; the illiquidity precludes your switching to better bargains.