In his 1986 Berkshire Hathaway Annual Letter, Warren Buffett explained how to use mathematical laws to make better stock market decisions. Here’s an excerpt from the letter:
Common stocks, of course, are the most fun. When conditions are right that is, when companies with good economics and good management sell well below intrinsic business value – stocks sometimes provide grand-slam home runs.
But we currently find no equities that come close to meeting our tests. This statement in no way translates into a stock market prediction: we have no idea – and never have had – whether the market is going to go up, down, or sideways in the near- or intermediate term future.
What we do know, however, is that occasional outbreaks of those two super-contagious diseases, fear and greed, will forever occur in the investment community. The timing of these epidemics will be unpredictable. And the market aberrations produced by them will be equally unpredictable, both as to duration and degree.
Therefore, we never try to anticipate the arrival or departure of either disease. Our goal is more modest: we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.
As this is written, little fear is visible in Wall Street. Instead, euphoria prevails – and why not? What could be more exhilarating than to participate in a bull market in which the rewards to owners of businesses become gloriously uncoupled from the plodding performances of the businesses themselves.
Unfortunately, however, stocks can’t outperform businesses indefinitely.
Indeed, because of the heavy transaction and investment management costs they bear, stockholders as a whole and over the long term must inevitably underperform the companies they own.
If American business, in aggregate, earns about 12% on equity annually, investors must end up earning significantly less. Bull markets can obscure mathematical laws, but they cannot repeal them.
You can read the entire letter here:
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