There has been growing talk in the past few months about high share valuations and the potential for a stock market crash. I do not know when the next crash will be. But there is one piece of advice from investing legend Warren Buffett I will be focussed on this year if the market does start to sink.
Warren Buffett on stock market crashes
Buffett was born the year after the infamous Wall Street crash of 1929. He has experienced plenty of crashes since then that have informed his investment approach. Indeed, in the 2008 crash a number of leading companies including Goldman Sachs looked to Buffett for cash infusions on a large scale.
So it is no surprise that Buffett has a lot to say as an investor about stock market crashes. One nugget of wisdom that particularly interests me is Buffett’s famous saying that an investor ought to be “be fearful when others are greedy and greedy when others are fearful“.
I think that summarises Buffett’s approach to responding to a stock market crash. At such a time, many investors are fearful. That can lead to them dumping quality shares at fire sale prices. In such a situation, an investor following Buffett’s approach can be “greedy” by buying up good shares at a cheap price.
What does being greedy mean?
But what exactly does Buffett mean by being greedy? To understand this, I think it is helpful to know about Buffett’s investment approach in general.
He does not buy shares simply because they are cheap. At one stage in his career, this was his strategy and in fact he had considerable success with it. But he moved away from buying shares he thought were cheap just because, for example, their share price was less than their net asset value. Instead, he shifted to buying companies he thought had the potential to be highly cash generative. Having identified such companies, he tries to buy them at an attractive price.
Handling a stock market crash
So when the stock market crashes and many investors are driven by fear, Buffett sees opportunity.
Such windows of opportunity can be short-lived. So I do not think they are a good moment to start scouring the market for bargains. Instead, it is helpful to form a shopping list of shares one is interested in owning. Then, if there is a sudden crash, it is easy to look at the prices of those shares and see whether they offer good value.
So, for example, I like the income earning potential of insurer Legal & General. I also like the entrenched customer base of Howdens Joinery. I reckon the pricing power of drinks maker Diageo could make it an attractive addition to my portfolio too. But other investors also like such attributes. There is a risk I could overpay for popular shares relative to their future earnings potential. I do not currently own any of these companies. But they are all on my watchlist.
If there is a stock market crash, I will look at their prices. If I regard them as attractive during a market rout, I will add them to my portfolio. Like Warren Buffett, I will take fear in the market as a signal to look for opportunities to build my own portfolio.