Tens of billions of dollars later, people who don’t consider Warren Buffett one of the greatest investors of all time are few and far between. One of the best things about Buffett’s success is that it didn’t take some never-before-seen or extraordinary investing strategy. In fact, you could argue it was just the opposite.
The Oracle of Omaha has made a living (to put it very lightly) by value investing. Value investing involves finding companies whose stock price is trading below their intrinsic value. By investing in an undervalued company, investors hope the stock market will one day price it at its true value, and they can benefit from that gap and hopefully beyond.
Bear markets can be a blessing
Bear markets are somewhat of a necessary evil. If stock prices only went up, that would go against one of the main principles of investing: Higher risk should mean higher expected returns. After all, if investors began to believe that stock prices only rise (essentially no risk), they would pour money into not-so-great businesses because they believe they’ll make money regardless. This would push prices up even more, making stocks overvalued and likely lowering future returns. There’s a reason bubbles pop.
Instead of looking at the negatives of bear markets, investors should view them as a chance to grab some great undervalued stocks or double down on their current holdings while prices may have been overcorrected during the current bear market. For example, during the short-lived bear market of early 2020, the S&P 500 (^GSPC -0.07%) fell by over 30%. Some investors panicked and sold their stocks, while others saw it as an opportunity. Since its March 2020 lows, the S&P 500 is up over 78% as of Aug. 9 — even while being down over 14% year to date.
Humans are notoriously irrational, and this irrationality is commonly reflected in the stock market. One of Warren Buffett’s most famous quotes is: “Be fearful when others are greedy, and greedy when others are fearful.” He understands that investors, against conventional investing wisdom, often go with the masses, even if it goes against their long-term interests. While others are fearful during a bear market, now’s the time to get greedy and look for discounts.
Don’t mistake price for value
I must admit: I’ve been guilty of looking at a stock’s low price and thinking to myself, “Well, since it’s only $4, I might as well buy it, since it’ll only have to go to $5 for me to make a 25% return.” If it were that easy, a lot more people would likely be rich. You never want to confuse a “cheap” price with value. That $4 stock could be overpriced, just as a $500 stock could be underpriced.
A better way to determine whether a stock is undervalued is by comparing its price-to-earnings (P/E) ratio to similar companies in its industry. You can find a company’s P/E ratio by dividing its current stock price by its earnings per share (EPS), and this essentially tells you how much you’re paying per dollar of the company’s earnings. If you’re looking at a company’s P/E ratio and it’s noticeably higher than comparable companies, that could be a sign it’s overvalued; if it’s noticeably lower, that could be a sign it’s undervalued.
Keep your eyes on the prize
If you’re investing for the long term (which you should be), the one thing you don’t want to do is let short-term stock market cycles have you making decisions that can hurt you in the long run. When you invest in a company, it should be because you believe in its long-term potential. And part of believing that is understanding that there will likely be some rough times along the way. None of us are immune to that.
Warren Buffett is one of the poster children of buy-and-hold investing, largely because he understands the power of time and compound interest. There’s a reason conventional investing wisdom says time in the market is more important than timing the market. Keep your eyes on the prize and understand that the short-term happenings in the stock market are often just noise on the way to achieving your financial goals.