What Warren Buffett says – and does – when markets fall

Important information - the value of investments and the income from them, can go down as well as up, so you may get back less than you invest.

Warren Buffett doesn’t try to predict the movements of the stock market or when the next fall is likely to occur. What he does do is judge when markets are looking expensive and ensure he is prepared for any future correction. He also knows in advance the type of company he will invest in if a drop does bring the opportunity to buy bargains. Private investors can do all these things too.  

Here we set out, using his own quotes, how Mr Buffett values markets and gets ready for falls when they happen.

Buffett’s favourite valuation tool

While other investors often use price-to-earnings ratios, the ‘Sage of Omaha’ uses a measure that’s arguably even simpler. He compares the value of the entire American stock market – in other words, the combined market value of every listed US company – with the country’s annual economic output. If the market’s value exceeds economic output by a wide margin, he gets worried. If the value of the market is less than economic output, he senses value.

In his own words: ‘If the percentage relationship [of stock market value to economic output] falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200% – as it did in 1999 and a part of 2000 [the dotcom bubble] – you are playing with fire.’¹

You can track the ratio, sometimes called the ‘Buffett indicator’, at the website gurufocus. The most recent figure, from a few days ago, is 170%.

Buffett doesn’t predict stock market falls, he prepares for them

If even Mr Buffett, widely feted as the world’s best investor, says he cannot predict stock market falls, what hope for the rest of us?

This reflects his ‘contrarian’ instincts: he buys when others are selling. 

In his own words: ‘The disarray in markets gave us a tailwind in our purchases. When investing, pessimism is your friend, euphoria the enemy.’⁶

He has a very simple formula for the stocks he buys.

In his own words: ‘We select our marketable [listed] equity securities in much the same way we would evaluate a business for acquisition in its entirety. We want the business to be (1) one that we can understand, (2) with favourable long-term prospects, (3) operated by honest and competent people, and (4) available at a very attractive price. We usually can identify a small number of potential investments meeting requirements (1), (2) and (3), but (4) often prevents action.’⁷

He says those who invest only when markets are placid pay a heavy price.

In his own words: ‘We’ve put a lot of money to work during the chaos of the last two years [the global financial crisis]. It’s been an ideal period for investors: A climate of fear is their best friend. Those who invest only when commentators are upbeat end up paying a heavy price for meaningless reassurance. In the end, what counts in investing is what you pay for a business – through the purchase of a small piece of it in the stock market – and what that business earns in the succeeding decade or two.’⁸

And no matter how dark the investment horizon may seem, he puts matters in their historical perspective and expresses optimism for the long term.

In his own words: ‘Amid this bad news, however, never forget that our country has faced far worse travails in the past. In the 20th Century alone, we dealt with two great wars (one of which we initially appeared to be losing); a dozen or so panics and recessions; virulent inflation that led to a 21.5% prime [interest] rate in 1980; and the Great Depression of the 1930s, when unemployment ranged between 15% and 25% for many years. America has had no shortage of challenges.

‘Without fail, however, we’ve overcome them. In the face of those obstacles – and many others – the real standard of living for Americans improved nearly seven-fold during the 1900s, while the Dow Jones Industrials rose from 66 to 11,497. Compare the record of this period with the dozens of centuries during which humans secured only tiny gains, if any, in how they lived.’⁹

• Read: How to invest in Warren Buffett’s Berkshire Hathaway
• Read: Generate your retirement income the Warren Buffett way
• Read: Market falls - your questions answered

Source:

¹Fortune magazine, December 2001
²Berkshire Hathaway annual report, 2001
3Letter to Berkshire Hathaway shareholders, 2009
⁴Remarks at Berkshire Hathaway annual meeting, 2024
⁵Letter to Berkshire Hathaway shareholders, 2009
⁶Letter to Berkshire Hathaway shareholders, 2009
⁷Letter to Berkshire Hathaway shareholders, 1979
⁸Letter to Berkshire Hathaway shareholders, 2010
⁹Letter to Berkshire Hathaway shareholders, 2009