When Warren Buffett speaks, investors tend to listen. Buffett’s Berkshire Hathaway (BRK.A) buys undervalued companies to hold for the long term, and between 1965 and 2016, the company returned an annualized 20.8 percent to its investors, in contrast with the S&P’s 9.7 percent return. The Nebraska billionaire’s long history of success has earned him the moniker “The Oracle of Omaha,” and many investors hang on his every word for insights on succeeding in the market.
One of Buffett’s most famous quotes is “Be fearful when others are greedy, and greedy when others are fearful.” This particular piece of investing wisdom is a contrarian recommendation — advising, essentially, to go against the investing grain. But implementing this strategy is more difficult than it appears.
Understanding How Markets Behave
Investment markets are cyclical. Stock prices rise, peak, fall, and then rebound. Investor sentiment changes along with the stock price trends: As prices rise, many investors see these market gains, get excited, and jump on the bandwagon by pouring money into the market. Buffett characterizes these return-chasing investors as “greedy,” seeking to profit from an increasing stock market.
Those greedy investors chasing a rising stock market tend to overlook a most important factor purchasing stocks: Price. Regardless of broad market trends, if you pay too high a price for a stock or fund, you’re likely to lose money when the market corrects and the price comes back to earth. That’s the nexus of why Buffett cautions against greed when investing.
Stock Market Valuation Matters
In a rising stock market, asset values tend to get inflated. For example, during the past 30 years, investors have paid a range of prices for one dollar of earnings, as measured by the Price Earnings (PE) ratio. From a low PE ratio of 11.69 in Dec 1988 to a peak of 122.39 in May 2009, this stock market price tag is a precursor to future stock market prices.
Higher current PE ratios predict lower future stock prices. Greedy, return-chasing investors buying into highly priced stocks are certain to experience lower returns going forward.
Then when the stock price uptrend turns around and goes south, and investors panic and get scared. These same investors who bought at market peaks turn around and sell during the subsequent market trough. These scared investors are doing exactly what Buffett warns against: Selling on fear.
As market prices fall, the PE values fall, and stocks get cheaper. Those savvy investors who buy when others are fearful, typically purchase undervalued, lower PE ratio stocks and enjoy higher returns in the future.
Buffett’s wisdom plays out in reality, as lower valued stocks outperform higher PE assets going forward and vice versa. So, to implement the Buffett advice, don’t get swayed by the crowd. When assets are richly valued, be cautious and don’t jump into the markets with all your investment dollars. As stock market values fall, be brave and pick up on-sale shares.
That all makes sense at first blush. But this advice seems to clash with another classic bit of investing wisdom.
“Don’t Fight the Tape”
“Don’t fight the tape” is another snippet of old investing advice, essentially warning investors not to trade against a trend. That wisdom suggests that rising stocks will continue to go up, and falling stocks will continue to decline. Thus, as stocks go up, if you practice the “don’t fight the tape” advice, you’ll continue to buy, regardless of the stock market PE ratio.
This saying describes the momentum investing strategy.
On the surface, Buffett’s advice seems to clash with the momentum strategy. Yet, there is some overlap. Buffett’s wisdom guides investors to invest in under- or fairly-valued assets with good future investment prospects. The “don’t fight the tape” camp recommends investing as long as stock prices are rising.
As stock prices rise, in the early stages of a bull market, stock prices may be undervalued. At this point in an economic cycle, both Buffett and momentum strategies are in accord.
Later, as stock market prices continue to soar, and surpass their intrinsic value, investors tend to get greedy and momentum investors continue to buy in. This is where the two investing camps diverge: Momentum investors pay less attention to a stock’s valuation and more attention to the price trend.
Reconciling the Strategies
The secret to smart investing strategy is to understand the value of your investments. If asset prices are substantially above their historical norms, and investors are giddy with enthusiasm, be cautious — and vice-versa Following trends is great if you know exactly when the trend will reverse course. If you don’t, then it’s best to understand market valuation and avoid paying too much for your financial assets.