There are two pillars of financial knowledge gaps that are the foundation of all investing and are paramount to your financial success in the stock market. First, the concept of "Market Fluctuations" and second, the concept of a "Margin of Safety."
Both concepts were developed and taught by Benjamin Graham in his book the Intelligent Investor. Warren Buffet states that chapter eight " The Investor and Market Fluctuations" and chapter twenty "Margin of Safety" are the two most important essays ever written on investing.
What are market fluctuations? They are changes in the value of a stock portfolio over time. They are the ups and downs of the financial markets. As an investor you MUST know about this certainty and be prepared for it both "financially and psychologically."
Allow me to illustrate this truth with a chart (the chart illustrates the S&P 500 comprised of the largest 500 companies by market cap in the US) notice that there is not a single year in the last 43 years where the stock market didn't have roller coaster ups and downs with average intra-year drops of 14.3%. Translating that into dollars, for every $100,000 you had invested in this index, at some point your account lost on avg $14,300.
Graham puts it this way: "...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." Graham is saying that history and human behavior guarantees that these fluctuation will happen every year. Markets are driven by momentum which leads to greedy and dangerous speculation. These types of fluctuations can be further magnified in different asset classes, for example, swings in Small Cap stocks like the Russell 2000 could see more fluctuations than the S&P 500.
Graham explains "that the stock market often goes far wrong" and it does so in both directions, it can become extremely overbought when FOMO takes hold and it can become extremely oversold when pessimism and fear take hold. Additionally, there is the slower moving change over time since "businesses change in character and quality over the years, sometimes for the better, perhaps more often for the worse." Indeed there are many factors that lead to market fluctuations, but being prepared and having an expectation that they will come every year is how we ought to approach investing in the stock market.
Graham uses the parable of Mr. Market who is your bi-polar business partner to explain the danger of having constant price quotations available to us. Every day Mr. Market tells you what the "business is worth and offers to buy you out or sell you an additional interest on that basis. Sometimes his idea of value appear plausible and justified by business developments and prospects as you know them." More often, "Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly." This parable pretty much sums up the daily moves in the stock market. Emotional momentum drives it in the short term, but in the long term the results from the businesses that make up the market are what drives value. As Warren Buffet so aptly puts it "In the short run, the market is a voting machine but in the long run, it is a weighing machine."
So ignore financial media as much as possible, they are Mr. Markets promoter and chief influencer. The financial medias main goal to have people constantly listening so they can generate a profit. It has an endless barrage of information for us, all of which is absolutely meaningless to the long term returns of the market. Some fan the flame of FOMO and some fear and pessimism. But YOU need to stay the course.
