Peter Lynch on Volatility vs Risk

Lynch's experience of the October 1987 crash is one of the most retold episodes in his public commentary, in part because he was on a golf course in Ireland when the market lost twenty-two percent in a single session. By the time he could reach a phone and understand what had happened to his portfolio, Magellan had dropped from roughly twelve billion dollars to roughly eight billion. The episode is often cited as a lesson in the futility of attempting to time the market — Lynch, despite being one of the most plugged-in investors in the world, did not see the crash coming and could not have acted on it if he had. Lynch's retrospective on the crash emphasised two lessons. First, the volatility of an equity portfolio is the cost of capturing the equity premium; the investor who cannot tolerate the cost cannot capture the premium. Magellan recovered from the 1987 crash within two years and went on to compound substantially through 1990. The investors who sold on October 19 or 20 of 1987 locked in their losses and missed the recovery. Second, the crash exposed which positions had been bought on leverage or on margin — those were the positions that had to be liquidated into the falling market, while the unleveraged positions could be held and ultimately recovered. The deeper methodological lesson Lynch drew was that the holder of unleveraged equity in fundamentally sound businesses does not need to forecast crashes. The investor whose positions are sized so that no single drawdown forces a sale, and whose businesses are sound enough to recover their earnings power after a macro shock, can sit through crashes by default. The 1987 crash was, in Lynch's framing, less a forecastable event than a stress test of portfolio construction. The portfolios that survived were the ones whose position sizes and balance sheets allowed them to do nothing — and doing nothing was, in 1987, the action that produced the best outcome.

The fact of the matter is, in the America that we live in, there are a lot of people who feel they have no choice, that they have to be in the market. What do those people do? Well, if people don't have the stomach, they really don't have it, the volatility's too much for them with the stock market, they can avoid it. They could buy money market funds and they'd get a little bit better than inflation. They will not get, in my opinion, the same return the next 20 years, the next 30 years they would get by buying stocks. That doesn't sound like much, but over the long period of time Treasury Bills and money markets have yielded a little bit higher than inflation, bonds have yielded five or six percent, and stocks have yielded a total of 11. The differences are massive over 30 years, but that's not a bad return to get a positive return. If you're worried, it's better than losing money.

[18:09] And it’s good when it happens {a market decline}. If you like a stock at $14 and it goes to $6, that’s great. You understand the company. You look at the balance sheet. They’re doing fine. You are hoping to get to $22 with it; $14 to $22 is terrific, $6 to $22 is exceptional, so you take advantage of these declines. They’re {declines} are going to happen, and no one knows when they’re going to happen. People will tell you after the fact that they predicted it, but they predicted it 53 times. So, you can take advantage of the volatility of the market if you understand what you own. So, I think that’s a key element.