The Most Unfortunate Thing Warren Buffett Ever Said

I admire Warren Buffett as much as the next person, but I believe most investors could do without one bit of his folksy wisdom: "If history books were the key to riches, the Forbes 400 would consist of librarians."

Buffett wrote this in his 1990 letter to shareholders of Berkshire Hathaway on the heels of the junk bond debacle of the 1980s. He was referring specifically to a "scholarly" finding that the higher yield of low-grade bonds had over time more than compensated for their higher rate of default.

Junk bond salesmen used this alleged fact, questionable even at the time, as evidence that a diversified portfolio of low-grade bonds would produce greater net returns than a portfolio of high-grade bonds.

It goes without saying that Buffett had a point. Historical data by its nature is susceptible to innocent misinterpretation, if not outright manipulation. On top of this, junk bonds were still a recent phenomenon in 1990, only growing in popularity throughout the previous decade. For all intents and purposes, they had no history.

But while Buffett's point is valid insofar as junk bonds were concerned, it becomes less so when taken out of context. For instance, consider the following paragraph from the 2007 book Finding the Next Starbucks: How to Identify and Invest in the Hot Stocks of Tomorrow:

The implication is that history does not matter at all -- that investors would be better off making guesses about the future than they would be reading about the past. But even beyond the fact that Buffett would not likely endorse such a broad interpretation of his statement -- he is, after all, a voracious reader -- any investors who fall for this logic do themselves a great disservice.

Why history mattersI say that because history does matter when it comes to investing. It matters a lot. "When we ignore history, we end up basing our actions on our own limited experience," wrote Carl Richards in The Behavior Gap. "That can be very dangerous."

This is because some general rules can be deduced from the historical ebbs and flows of the economy and Wall Street.

For example, history shows us the folly of chasing the next great investment fad. Railroad stocks were all the rage following the Civil War, but by the mid-1890s more than a third of the country's railways had fallen into receivership. Latin American bonds were hot in the 1920s, but they suffered almost universal default a decade later. More recently, there was the dot-com bubble, which peaked in 1999 and burst the follow year.

In each instance, investors told themselves things were different, that the economy and the stock market no longer abided by the inviolable rules of the past. And in each of these instances, the investors who ignored history paid the heaviest price to discover that the rules still applied.

This is because history proceeds in cycles: political cycles, social cycles, economic cycles, market cycles, and so on. Take the bank industry as an example. When the economy is roaring, lenders drop their guard and become more generous with credit. Then, when the economy takes a turn for the worse, they suffer the consequences by either failing outright or by diluting shareholders in a desperate attempt to raise capital. Over the last two centuries, this has happenedno less than 17 times, or once every dozen or so years.

History also teaches us about the arc of technological change and the corporate life cycle. Half a century ago, Polaroid was one of the hottest stocks on Wall Street, as was Eastman Kodak. At another point, Sears Roebuck and F.W. Woolworth were the nation's leading retailers. Indeed, less than a decade ago, now-ailing retailersBest Buy and Barnes & Noble were rapidly expanding, seemingly ignorant of the existential threat posed by e-commerce.

But perhaps most important of all, even a rudimentary understanding of history equips investors with optimism about the future. Yes, as I said, economies move in cycles -- but the general trend is up. Ten years from now, stocks will be higher than they are today. Ten years from then, they'll be even higher. If they aren't, we'll have bigger problems than the value of our portfolios. Suffice it to say that optimism like this is a rare but critical component of successful long-term investing.

History as a competitive advantageOver the last few weeks, I've read through the memoirs of five of history's greatest stock operators and investors. Almost without exception, every one of them emphasized the repetition of history. "No statement is more true and better applicable to Wall Street than the famous warning of Santayana: 'Those who do not remember the past are condemned to repeat it,'" wrote Buffett's mentor, Benjamin Graham.

My point is that history matters. I'd even go so far as to say that knowledge of the past, given how rare it is nowadays, is a potent competitive advantage for the average investor. Thus, to slightly reframe Bufffett's words, while history might not be the key to riches, it certainly deserves a spot on the enterprising investor's key chain.

The article The Most Unfortunate Thing Warren Buffett Ever Said originally appeared on Fool.com.

John Maxfield has no position in any stocks mentioned. The Motley Fool owns shares of Barnes & Noble. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.