Here's the Very Good Reason Warren Buffett Scared Everyone This Year

The only question is... did he scare them enough?

There are a million reasons for investors to go and read Warren Buffett's annual letter to Berkshire Hathaway Inc. (NYSE: BRK.A) shareholders. In fact, at this point - let's face it - they're really letters to every single shareholder on Earth.

In these letters, you're absolutely guaranteed to find some of the most uncommon common sense in all of Anglo-American capitalist thought, as well as fundamentally sound arguments and insights colored by deep experience.

In other words, the "Oracle of Omaha," the stock market's friendly, shrewd, and unreasonably rich grandpa, dishes really good stuff in these letters - in plain, Nebraska-accented English, to boot.

But here's the catch: If you're going to "invest like Buffett," you absolutely, positively must be prepared to hang tough like Buffett...

...and, inevitably, you have to be ready to hemorrhage money like Buffett.

That is exactly why what the Oracle of Omaha said this year was so shocking to the uninitiated.

Turns out, sometimes the Oracle's job is to scare the living daylights out of you - go ask any ancient Greek you meet at the bar.

Here's the hard truth...

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Now... Here's What Buffett Said

In this year's shareholder letter, Warren Buffett went "back to the future."

There was a very simple table... representing some very "interesting" days to be a Berkshire shareholder.

Period Loss in Berkshire Stock
March 1973 to January 1975 59.1%
Oct. 2 to Oct. 27, 1987 37.1%
June 1998 to March 2000 48.9%
Sept. 2008 to March 2009 50.7%

Of course, these are the four considerable declines in Berkshire shares that have happened over the decades.

Buffett warned, "in the next 53 years our shares (and others) will experience declines resembling those in the table. No one can tell you when these will happen. The light can at any time go from green to red without pausing at yellow." He has made similar statements in the past. One of the most widely quoted Buffett sayings is "Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market."

Buffett wasn't talking out of turn, either.

Berkshire Vice Chair Charlie Munger has voiced similar sentiments, telling investors at the 2017 meeting of the Daily Journal Co. (DJCO) that "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 result you're going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations."

Strong stuff.

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Buffett takes it a step further. He once said, "I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years." He also advised that significant declines were a happy event for those who were actual investors and not just thinly disguised traders.

The Oracle has always been forthright, continually warning that stocks would decline from time to time, and those who panic and sell will be all the worse off for doing so.

This couldn't be clearer or more straightforward (it is Warren Buffett we're talking about here), and yet, invariably, people read Buffett's advice and then radically misapply it.

Take the "Buffettologists," for instance. They repeat these axioms constantly.

Why Some of Buffett's Biggest Fans Get It So Wrong

warren buffett buys apple stockIf you are not familiar with Buffettologists, they are those investors who regularly quote Buffett and can opine endlessly about "return on equity" and "wide moats." They get up at 6 a.m. to read the shareholder letter in February, and they've invariably scrapped together a few grand so they can own BRK.B shares of Berkshire... and qualify for entry to the annual gathering in Omaha every May.

They only own stocks that Berkshire owns and take great pride in staying inside their circle of competence.

But... like a robin at the first snowflake, most "Buffettologists" disappear when the selling starts in earnest.

Turns out, it's one thing to talk about owning a stock that drops 50% or more and quite another to live through it.

You see, a bear market tends to test a borrowed philosophy to its limits - to the very breaking point - and most "sunny-day Buffettologists" will fail to heed the maxims of their guru.

In truth, however, it is very difficult to get rich in stocks without enduring the kinds of dizzying declines Buffett is warning folks about.

Virtually without exception, every great stock has, at some point, undergone a gut-wrenching decline of vomit-inducing speed and intensity.

The thing is, it's been a while since we've endured a bad market.

Millions of Investors Are Unprepared for the Inevitable

Hell, there are probably lots of licensed financial advisors and institutional investors handling real money who don't really remember the crisis years in any meaningful way; money managers whose only real experience has been with cheap, easy money and radically inflating stock prices.

So, if they ever knew it in the first place, folks have forgotten fun, exciting things like The Walt Disney Co. (NYSE: DIS) declining by 50% in 2008 and 2009, or Inc. (Nasdaq: AMZN) plunging from over $50 a share to $10 and change back in the dot-com bust.

Netflix Inc. (Nasdaq: NFLX), for instance, has been a fantastic stock. But the last decade has seen some declines that shook out all but the very strongest investors.

Berkshire Hathaway shares have seen three declines of about 50% over the past 53 years, and it took some courage and emotional character to hold on through the selling no matter how much you admire Buffett's pithy proclamations.

Like the man himself, I've been at this for a long time - more than 30 years now. I have lived through three major crashes and countless mini meltdowns. The cycle is as inevitable as the sunrise.

About three years after a market bottom, the Buffettologists and "growth stock experts" begin to emerge from hiding and start once again giving expert advice on investing. At the first 20% decline, they go back into hiding until the markets are rising once again.

These folks are flawless at selling low and buying high, while driving their family and friends slowly insane with their delusions of investing grandeur. Investing is easy to talk about in a bull market and much more difficult to execute amidst prices falling like December snow in Buffalo.

The upshot: Warren and Charlie are right. Of course they are.

If your goal is to earn unreasonably high returns in the stock market, you will at some point be on the business end of a 50% decline.

It could be market- or sector-driven, or merely a market reaction to a bad earnings report.

I won't lie to you: It is going to suck in the moment. The key is not to panic and just sell blindly.

You've got to ask and answer honestly some tough questions.

Why did you buy the stock in the first place? Is that still valid - has anything happened to change the business case for owning the company? Is the company financially strong enough to survive until the company and stock price recover? Has the business changed, or am I selling Amazon at $11?

If the answer to those question is, "yes," then it's probably a good idea to tighten your gut muscles, enjoy the free fall, and buy some more.

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About the Author

Tim Melvin is an unlikely investment expert by any measure. Raised in the "projects" of Baltimore by a single mother, he never attended college and started out as a door-to-door vacuum salesman. But he knew the real money was in the stock market, so he set sights on investing - and by sheer force of determination, he eventually became a financial advisor to millionaires. Today, after 30 years of managing money for some of the wealthiest people in the world, he draws on his experience to help investors find "unreasonably good" bargain stocks, multiply profits, and build their nest eggs. Tim tirelessly works to find overlooked "hidden gems" in the stock market, drawing on the research of legendary investors like Benjamin Graham, Walter Schloss, and Marty Whitman. He has written and lectured extensively on the markets, with work appearing on Benzinga, Real Money, Daily Speculations, and more. He has published several books in the "Little Book of" Investment Series and a "Junior Chamber Course" geared towards young adults that teaches Graham's principles and techniques to a new generation of investors. Today, he serves as the Special Situations Strategist at Money Morning and the editor of Peak Yield Investor.

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