Learning to love market crashes

Rather than panic, experienced investors view crashes as opportunities.

a woman

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It's been an incredible week on our markets. Volatility has been king, and the 'herd' has been desperately looking for someone to follow. In the first 8 trading days of August, the S&P/ASX 200 has seen daily gains of more than 2.5% and drops of 4% – in fact, the smallest daily change  was 1.2%.

In two consecutive days earlier this week, the Dow Jones index experienced one of the worst 10 days in its history, in terms of points decline, followed the very next day by one of its ten best. If that's not a market floundering for direction, I don't know what is.

Herd behaviour presents opportunity

Far from suggesting that as a problem, however, this reactionary behaviour is the long-term investor's friend. The volatility in the markets this week has very little to do with the long term prospects of the companies listed on the exchanges, and everything to do with investor nervousness about the short term prospects of the economy.

I wouldn't want to be trading this market. In fact, I wouldn't try to trade any market, but that's a different story. Trying to guess where the market is going in 5, 30 or 90 days is a devilishly difficult pursuit – and one we can simply ignore.

Instead, patience is the key for long term success. Benjamin Graham, Warren Buffett's mentor and famed value investor, first gave us the parable of Mr. Market. In his book, The Intelligent Investor, he introduces us to the fictional character who represents the skittish herd mentality of share markets.

Form your own view of value

Graham's Mr. Market often offers to buy your shares or sell you his at a reasonable price – at other times, he gets a little carried away and, as Graham says 'lets his enthusiasm or his fears run away with him'. Fittingly, Graham offers this challenge:

"If you are a prudent investor or a sensible businessman, will you let Mr. Market's daily communication determine your view of the value of your … interest in the enterprise? … You will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position."

Volatility does not equal risk

Done prudently, share investing (at the portfolio level) need not be risky. It will certainly be volatile, but only in certain textbooks does volatility equal risk. In the real world, risk is the chance you'll lose money. I'm clearly not saying investors won't lose money in shares, nor am I saying every company will make money.

Instead, history shows that a well-chosen, appropriately diversified portfolio, held with a long term view has been a wonderful place to invest money you don't need in the short-medium term. Wealth creation has been the result, with the Australian stock market returning an average of around 11% per annum.

Famed investor Peter Lynch has said:

"Everyone has the brainpower to make money in stocks. Not everyone has the stomach. If you are susceptible to selling everything in a panic, you ought to avoid stocks and stock mutual funds altogether".

Foolish take-away

I've been there – in my early investing career, I bought on a whim, and sold after a drop. I was skittish, and followed the crowd.

When the market has bad days, my portfolio feels it and so do I. It's a horrible feeling. But experience, perspective and plenty of reading has taught me that while the bears may be in the ascendancy now, the bulls are never too far away – and over time, the bulls win.

These days, the confidence I gain from picking good companies, with bright futures and at attractive prices means I can face the dips with my finger hovering over the 'buy' button, rather than 'sell'.

History (and common sense) tells me that's the right approach for a long term investor, and that gives me the 'stomach' to face the challenging days with optimism. Developing your own tolerance through experience, learning and prudent share selection can do the same for you.

Scott Phillips is The Motley Fool's feature columnist. The Motley Fool's purpose is to educate, amuse and enrich investors. Motley Fool readers readers can click here to request a new free report titled Read This Before The Market Crashes.

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