Why Warren Buffett and Charlie Munger Were Right

Irrational Investor Behavior Abounds During Market Collapse

Warren Buffett and Charlie Munger were right about irrational behavior during stock market crashes.
Warren Buffett and Charlie Munger have been proven right over and over: When stock market collapses, most people will not behave rationally and buy ownership in great businesses with strong financial statements even though they were clamoring to buy those same businesses prior to the economic storm. Fear takes them over and the inevitable 30%, 40%, or 50%+ drop in market price causes them to behave in a sub-optimal manner. Getty Images News

More than a decade ago, I was attending a Berkshire Hathaway shareholder meeting and something legendary billionaire investors Warren Buffett and Charlie Munger said struck me as odd. When asked why they weren’t concerned about sharing their highly successful value investing method, the two men insisted that they believed it was the right way to behave to create a better society, while noting that most people wouldn’t, actually, adhere to anything they said during the next crisis; that most of the people listening to them would ignore what they had learned and refuse to behave logically.

Although I have tremendous respect for both men, I found that surprisingly depressing.

Years later, I saw firsthand how they were right. As I wrote on March 21st, 2009 when the Dow Jones Industrial Average had reached bottom following the worst collapse in generations, "... here we are in the midst of the greatest asset devaluation in generations and otherwise sensible people are behaving in ways so irrational I almost find myself not bothering to correct them anymore. One of my close family members now insists that owning stocks, or indeed, businesses in general, is nothing but a gamble. In his or her mind, however, working for that same company isn’t risky. The failure in logic should be obvious but for some reason, most people would rather have the illusion of job security (and it is an illusion, mind you) rather than the security of controlling their own destiny because the latter requires the fortitude to watch the asset values on your balance sheet fluctuate."

As someone who has gone through the journey of building wealth from scratch, let me say: The process of growing your net worth is not likely to be a steady, easy ride up like an escalator. Instead, it’s more probable it will come in fits and starts, with long periods in between where the wiser spend their time studying, reading, and amassing resources to take advantage of the opportunities that inevitably manifest.

That is the reason I was so forceful in that same piece when I asserted, "There is metaphorical blood running in the streets now and those with the resources, courage, and willingness to take advantage of the greatest fire sale on business ownership in the past half century will find themselves decidedly richer ten years hence. For now, when people begin ranting on the stock market or on taking risks, I find myself grimacing and walking away, feeling bad because they truly believe they are acting rationally. They’ll look back, wondering why [others] amass[ed] wealth."

It's been almost seven years. As with every time before, history was no different. Despite all of the fear, those who held onto their wonderful businesses, reinvested dividends, and kept buying more through the maelstrom made a lot of money. Real estate investors smart enough to pick up foreclosed houses are thrilled.  

Interestingly, the same folks who were bailing out at bottom piled back in following the longest bull market in global history. I've listened to investors argue for 100% equity allocations the higher stock prices rise. I regularly see people asking if they should take out student loan debt to invest in the stock market.

On several financial forums, I've even started seeing people criticize others for maintaining large emergency cash reserves, "You're losing compounding!" they say with urgency.

It's the same pattern setting itself to play out, again. The market will crash at some point - it always does, it's the nature of the auction mechanism - and otherwise smart people will liquidate their incredible holdings in even the strongest company; e.g., Johnson & Johnson, which is one of only four companies in the entire S&P 500 with an AAA rating on its corporate bonds, indicating the strength of the capitalization structure.

Before that happens, remember what I'm about to tell you: Making money from your portfolio isn't difficult. For the few of you that aspire to become financially independent, consider the following things:

  • Build a complete portfolio. This is the first and most important step so you should take the time to read the accompanying article by following the link.
  • Utilize the Berkshire Hathaway model by diversifying not only your assets but your active and passive income streams. This will enable you to survive financial catastrophes because you aren’t dependent upon a single job or revenue source.
  • Continue to seek value but only invest in the things you know, understand, and can explain to your children. In my case, I can understand the implication of changing discount rates and pension return assumptions on the reported earnings figures of publicly traded corporations. You probably can’t. That doesn’t have to hold you back because but you might have a much better grasp in a different field. Think about the people that understood the potential for cell phones in the United States and bought up spectrum space for only a few hundred dollars, later selling it for tens or hundreds of millions to telecommunication companies! Your most valuable asset is your knowledge base – it is unique and you should take advantage of it.