Warren Buffett has imparted a lot of market wisdom over his decades of investing. Some of it’s witty. Some seems fairly obvious once you think about it.
A few of his more serious nuggets involve warnings — in other words, you’ll put your portfolio in danger if you don’t wise up. 1999 is a perfect example. Stocks prices were soaring as the internet began transforming the global economy and the way we live. Investors had begun growing accustomed to huge returns.
Buffett saw the problem though. The tech revolution was just fine, but the expectation of what investors thought it would do for their portfolios wasn’t. In his 1999 letter to Berkshire Hathaway (BRKA -0.09%)(BRKB +0.06%) shareholders, Buffett wrote that investors were getting “wildly optimistic” about future returns from stocks.
The subsequent tech bubble crash proved him right. While we may or may not be in a bubble today, the lesson itself is one investors shouldn’t ignore.
Source: Getty Images.
Investors expected 19% annual returns
Warren Buffett has always understand the idea of relative value really well. It usually applies to his preference to buy quality companies at discount prices. But the opposite is always true.
Over the long-term, asset prices need to be tied to fundamentals. You can have periods where stocks are overvalued or undervalued relative to historical norms. But they generally can’t remain that way forever.
In his 2000 letter to Berkshire Hathaway shareholders, Buffett cited a PaineWebber-Gallup that asked investors what type of annual return they expected to see from stocks in the next decade. The average response was 19%.
Keep in mind that the S&P 500 was coming off of a 34% gain in 1995, 20% in 1996, 31% in 1997, 27% in 1998, and 20% in 1999. So it’s pretty clear where that belief was coming from. But the fact that the S&P 500 over the long-term has generated an average annual return of roughly 10%, it’s obvious that this trend wouldn’t last indefinitely.
The tech bubble took care of those expectations in a hurry, but it’s why Buffett’s warning is important. Being disconnected from reality for too long can do a lot of damage to your portfolio.
What investors should do with Buffett’s warning today
The wrong response would be to make radical changes to your asset allocation because valuations look high. Buffett has never really tried to forecast what the market was going to do next. He does, however, use valuation measures to suggest whether it’s an attractive time to buy stocks or investors are “playing with fire” as he once put it.
Your best bet is to avoid using unusually high stock market returns when trying to project how your portfolio might grow over time. It’ll just give you an overoptimistic result which could cause you to undersave for your financial goals.
Also make sure that your asset allocation is in line with your time horizon and risk tolerance. It’s OK to make some defensive shifts within the equity portion of your portfolio. It’s generally not a good idea to go from 100% stocks to 100% cash because of what you think might happen.
Buffett’s warning isn’t that investors should fear putting their money into stocks. It’s that enthusiasm shouldn’t override discipline and realistic expectations.
