During the third week of October in 1987 when stock prices declined by over 30% in two days, Peter Lynch (the legendary mutual fund manager that generated 29% annual returns over a thirteen-year stretch) learned that the Magellan Fund had lost $2 billion (about 20% of the fund’s assets under management) and had to deal with a rush of redemptions on the fund. Even though Lynch was the best mutual fund manager in his day, and even though his Magellan Fund owned a mixture of the highest quality and fastest growing companies in the world (a total of over 1,000 of them!), he still had to deal with so many redemptions that he had to strategically sell off some of his stocks (for the record, Lynch sold off most of the Magellan Fund’s British holdings because the British stocks had not gotten hit as badly as the American counterparts).
This is a huge structural advantage that you can possess over the mutual fund industry. When stock prices fall 10%, 15%, 20% (or whatever), most investors in mutual funds have the knee-jerk response to “sell now and ask questions later.” This puts mutual fund managers in the dilemma of having to get rid of the best performers to meet redemptions, even if they have the wisdom and foresight to know that it is a great time to go on a buying spree. Managers like Lynch can’t go on buying sprees unless they have money coming in (or if they are like Seth Klarman and keep 40% of the fund in cash).
But you don’t have to be like them—there is no rule that says that you have to be the “average” investor that sells when times get rough. There is nothing to prevent you from being the person buying Procter & Gamble at $44 per share in 2009 from the person that is selling it. People say stuff like, “75% of professional money managers haven’t beaten a basic index over the past X amount of years.” If those statements are true, it’s not necessarily because the money manager is incompetent. During times of crisis, money managers have their hands tied up to prevent them from buying stock because their investors are pressing the sell, sell, sell button with their mutual fund shares. The good news is that you don’t have to be like that—do whatever it takes to put yourself in the position of being a net buyer of stocks during times of 20%, 30%, and 40% declines. That is almost the entire battle. A focus on dividends and underlying profits is a great way to put yourself in a position to be a buyer during these times, but if you have some other technique that gets you the same results, then do it. Being a buyer during stock market declines is probably the single most important characteristic trait that you can possess as an investor.