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Over 35 Years of Reliable Investing™ The Wisdom of Great Investors Insights from Some of History’s Greatest Investment Minds We hope this collection of wisdom serves as a valuable guide as you navigate an ever-changing market environment and build long-term wealth. wisdom m Table of Contents The Wisdom of Great Investors 1 Avoid Self-Destructive Investor Behavior 2 Understand That Crises Are Inevitable 3 Don’t Attempt to Time the Market 4 Be Patient 5 Don’t Let Emotions Guide Your Investment Decisions 6 Recognize That Short-Term Underperformance Is Inevitable 7 Disregard Short-Term Forecasts and Predictions 8 Conclusion 9 Summary 10 Cover photos (left to right): Shelby Cullom Davis, Warren Buffett, Benjamin Graham, and Peter Lynch Photo credits: Peter Lynch, ©Alen MacWeeney/CORBIS; Warren Buffett, ©John Abbott/CORBIS i The Wisdom of Great Investors During extreme periods for the market, investors often make decisions that can undermine their ability to build long-term wealth. When faced with such periods, it can be very valuable to look back in history and study closely the timeless principles that have guided the investment decisions of some of history’s greatest investors through both good and bad markets. By studying these great investors, we can learn many important lessons about the mindset required to build long-term wealth. With this goal in mind, the following pages offer the wisdom of many of history’s most successful investment minds, including, but not limited to; Warren Buffett, Chairman of Berkshire Hathaway and one of the most successful investors in history; Benjamin Graham, recognized as the “Father of Value Investing” and one of the most influential figures in the investment industry; Peter Lynch, portfolio manager and author, and Shelby Cullom Davis, a legendary investor who turned a $100,000 investment in stocks in 1947 into over $800 million at the time of his death in 1994.1 Though each of these great investors offers perspective on a distinct topic, the common theme is that a disciplined, patient, unemotional investment approach is required to reach your long-term financial goals. We hope this collection of wisdom serves as a valuable guide as you navigate an ever-changing market environment and build long-term wealth. Equity markets are volatile and an investor may lose money. Past performance is not a guarantee of future results. Shelby Cullom Davis borrowed $100,000 in 1947 and turned it into an $800 million fortune by the year 1994. While Shelby Cullom Davis’ success forms the basis of the Davis investment discipline, this was an extraordinary achievement and other investors may not enjoy the same success. 1 1 Avoid Self-Destructive Investor Behavior “Individuals who cannot master their emotions are ill-suited to profit from the investment process.” Benjamin Graham. Father of Value Investing Emotions can wreak havoc on an investor’s ability to build long-term wealth. This phenomenon is illustrated in the study below. Over the period from 1988-2007, the average stock fund returned 11.6% annually, while the average stock fund investor earned only 4.5%. Why did investors sacrifice nearly two-thirds of their potential return? Driven by emotions like fear and greed, they engaged in such negative behaviors as chasing the hot manager or asset class, avoiding areas of the market that were out of favor, attempting to time the market, or otherwise abandoning their investment plan. Great investors throughout history have understood that building long-term wealth requires the ability to control one’s emotions and avoid self-destructive investor behavior. Average Stock Fund Return vs. Average Stock Fund Investor Return (1988–2007) Average Annual Return 15% 11.6% 10% The “Investor Behavior” Penalty 5% 4.5% 0% Average Stock Fund Return Average Stock Fund Investor Return Source: Quantitative Analysis of Investor Behavior by Dalbar, Inc. (July 2008) and Lipper. Dalbar computed the “average stock fund investor” returns by using industry cash flow reports from the Investment Company Institute. The “average stock fund return” figures represent the average return for all funds listed in Lipper’s U.S. Diversified Equity fund classification model. Dalbar also measured the behavior of a “systematic investor” and “asset allocation investor”. The annualized return for these investor types was 5.8% and 3.5% respectively over the time frame measured. All Dalbar returns were computed using the S&P 500® Index. Returns assume reinvestment of dividends and capital gain distributions. Past performance is not a guarantee of future results. 2 Understand That Crises Are Inevitable “History provides a crucial insight regarding market crises: They are inevitable, painful, and ultimately surmountable.” Shelby M.C. Davis. Advisor and Founder, Davis Advisors History has taught that investors in stocks will always encounter crises and uncertainty, yet the market has continued to grow over the long term. The chart below highlights the myriad crises that faced investors over the past four decades, along with the performance of the S&P 500® Index over the same time period. Investors in the 1970s were faced with stagflation, rising energy prices and a stock market that plummeted 44% in two years. Investors in the 1980s dealt with the collapse of the major Wall Street investment bank Drexel Burnham Lambert and Black Monday, when the market crashed over 22% in one day. In the 1990s, investors had to weather the S&L Crisis, the failure and ultimate bailout of hedge fund Long Term Capital Management and the Asian financial crises. Investors in the beginning of the 2000s experienced the bursting of the technology and telecom bubble, 9/11 and the advent of two wars. Today, investors are faced with the collapse of residential real estate prices, economic uncertainty and a turmoil in the financial services industry. Through all these crises, the long-term upward progress of the stock market has not been derailed. Investors who bear in mind that the market has grown despite crises and uncertainty may be less likely to overreact when faced with these events, more likely to avoid making drastic changes to their investment plans and better positioned to benefit from the long-term growth potential of equities. Despite Decades of Uncertainty, the Historical Trend of the Stock Market Has Been Positive S&P 500® Index 12/31/07 1,600 1,400 1,200 The 1980s 1,000 800 Today 600 Junk Bonds, LBOs, Black Monday The 1970s 400 Sub-Prime Debacle, Economic Uncertainty, Financial Crisis Nifty-50, Inflation, ‘73-’74 Bear Market 200 100 60 70 72 74 76 78 80 82 84 86 88 90 The 1990s The 2000s S&L Crisis, Russian Default, Long Term Capital, Asian Contagion Internet Bubble, Tech Wreck, Telecom Bust 92 94 96 98 00 02 04 06 07 Source: Yahoo Finance. Graph represents the S&P 500 Index from January 1, 1970 through December 31, 2007. Past performance is not a guarantee of future results. ® 3 Don’t Attempt to Time the Market “Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in the corrections themselves.” Peter Lynch. Legendary Investor and Author Market corrections often cause investors to abandon their investment plan, moving out of stocks with the intention of moving back in when things seem better–often to disastrous results. The chart below compares the 15 year returns of equity investors (S&P 500® Index) who remained invested over the entire period to those who missed just the best 10, 30, 60 or 90 trading days: n The patient investor who remained invested during the entire 15 year period received the highest average annualized return of 10.5% per year. n The investor who missed the best 30 trading days over this 15 year period saw his return plummet to only 2.2%. n Amazingly, an investor needed only to miss the best 60 days for his return to turn negative! Investors who understand that timing the market is a loser’s game will be less prone to reacting to shortterm extremes in the market and more likely to adhere to their long-term investment plan. The Danger of Trying to Time the Market 15 Year Average Annual Returns (1993–2007) 15 Year Average Annual Return 15% 10% 10.5% 7.1% 5% 2.2% 0% – 3.2% –5% –10% –7.4% Stayed the Course Missed Best 10 Days Missed Best 30 Days Investor Profile Missed Best 60 Days Missed Best 90 Days Source: Bloomberg and Davis Advisors. The market is represented by the S&P 500® Index. Past performance is not a guarantee of future results. 4 Be Patient “Despite inevitable periods of uncertainty, stocks have rewarded patient, long-term investors.” Christopher C. Davis. Portfolio Manager, Davis Advisors One of the most common attributes among great investors is patience. They recognize that while the mood of the market may cause a stock price to fluctuate widely over the short term, over longer periods the value of the underlying business often asserts itself. The two charts below illustrate the average annual returns for stocks over one year and five year periods from 1928–2007. The top chart indicates that stocks delivered a positive return in 59 out of 80 one year periods (74% of the time). The lower chart indicates that by extending the holding period to only five years, stocks delivered a positive return 93% of the time (71 out of 76 periods). When weathering a challenging period for the market, remember that throughout history, stocks have rewarded patient, long-term investors. Such perspective may help you avoid making a decision that can hamper your ability to reach your financial goals. One Year Annual Return One Year Returns for the Dow Jones Industrial Average 80% 70% 60% 50% 40% 30% 20% 10% 0% –10% –20% –30% –40% –50% 80 70 60 50 40 30 20 10 0 -10 -20 28 32 36 40 44 48 52 56 60 64 68 72 76 Five Year Returns for the Dow Jones Industrial Average Five Year Average Annual Return (1928–2007) 80 84 88 92 96 00 04 07 -30 -40 -50 28 30 32 34 38 40 (Five Year Periods Ending 1932–2007) 30% 30 25% 25 20% 20 15% 15 10% 10 5% 5 0% 0 –5% -5 –10% -10 -15 –15% –20% 36 32 36 40 44 48 52 56 60 64 68 72 76 80 84 88 92 96 00 04 -20 07 32 Source: The performance was obtained from a combination of sources, including, but not limited to, Thomson Financial, Lipper and index websites. Returns are annualized total returns. Past performance is not a guarantee of future results. 5 33 34 35 36 Don’t Let Emotions Guide Your Investment Decisions “Be fearful when others are greedy. Be greedy when others are fearful.” Warren Buffett. Chairman, Berkshire Hathaway Building long-term wealth requires counter-emotional investment decisions–like buying at times of maximum pessimism or resisting the euphoria around investments that have recently outperformed. Unfortunately, as the study below shows, investors as a group too often let emotions guide their investment decisions. The line in the chart below represents the amount of money investors added to domestic stock funds each year from January 1997–June 2008, while the bars represent the yearly returns for stock funds. Following three years of stellar returns for stock funds from 1997–1999, euphoric investors added money in record amounts in 2000, just in time to experience three terrible years of returns from 2000–2002. On the heels of these three terrible years, investors turned pessimistic and placed far less money into stock funds in 2002, right before stocks delivered one of their best returns ever in 2003 (29.7%). After a difficult start to 2008, fearful investors pulled money from stock funds. Great investors recognize that an unemotional, objective, disciplined investment approach, which often includes buying at times of maximum pessimism and exploring out-of-favor areas at times of maximum optimism, is a key to building long-term wealth. Domestic Equity Fund Returns vs. Net New Flows (1/1/97–6/30/08) Stocks deliver strong returns and euphoric investors push flows to an all-time high right before the collapse. 240 200 160 24.2 120 18.2 35 25 20 21.0 15 80 13.7 11.5 40 –2.8 –40 –80 5 0 After a period of poor returns, fearful investors become cautious and miss the recovery. –14.0 –120 10 6.9 7.1 0 –9.0 1997 1998 1999 2000 2001 2002 –5 –10 –15 –21.4 –160 –200 30 29.7 + – Calendar Year Return (%) Yearly Net New Flows ($Billions) 280 –20 2003 2004 2005 2006 2007 6/08 –25 Source: Morningstar and Strategic Research Institute as of June 30, 2008. Past performance is not a guarantee of future results. 6 Recognize That Short-Term Underperformance Is Inevitable “The basic question facing us is whether it’s possible for a superior investment manager to underperform....The assumption widely held is ’no.’ And yet if you look at the records, it’s not only possible, it’s inevitable.” Robert Kirby. Founder, Capital Guardian Trust Company When faced with short-term underperformance from an investment manager, investors may lose conviction and switch to another manager. Unfortunately, when evaluating managers, short-term performance is not a strong indicator of long-term success. The study below illustrates the percent of top-performing large cap investment managers from January 1, 1998 to December 31, 2007 who suffered through a three year period of underperformance. The results are staggering: n 98% of these top managers’ rankings fell to the bottom half of their peers for at least one three year period n A full 75% ranked among the bottom quartile of their peers for at least one three year period, and n 43% ranked in the bottom decile for at least one three year period. Though each of the managers in the study delivered excellent long-term returns, almost all suffered through a difficult period. Investors who recognize and prepare for the fact that short-term underperformance is inevitable– even from the best managers–may be less likely to make unnecessary and often destructive changes to their investment plans. Percentage of Top Quartile Large Cap Equity Managers Whose Performance Fell Into the Bottom Half, Quartile or Decile for at Least One Three Year Period 100% 98% 80% 75% 60% 40% 43% 20% 0% Bottom Half Bottom Quartile Bottom Decile Source: Davis Advisors. 160 managers from eVestment Alliance’s large cap universe whose 10 year average annualized performance ranked in the top quartile from January 1, 1998–December 31, 2007. Past performance is not a guarantee of future results. 7