"People tend to underestimate low-probability events when they haven't happened recently and overestimate them when they have happened recently," Warren Buffett (Trades, Portfolio) once said. This comment couldn't be more appropriate in the current market environment.
At the end of 2019, the last thing on investors' minds was a pandemic. It looked as if the global economy was finally picking up steam after years of stagnation, ready to continue its 11-year bull market run.
Now, investors must adapt to a new normal. Stock markets around the world are plunging, and it does not look as if anything is going to arrest these declines any time soon.
Preparing for the unknown
As investors, we have to prepare for these events, no matter how slim the odds of them happening are. It is almost impossible to prepare for every black swan event, but we can increase our chances of avoiding disaster by taking a few key actions.
The most important of these is avoiding leverage and avoiding companies that rely heavily on borrowing to keep the lights on. This is a point Buffett made at the 2004 Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) annual shareholder meeting.
Buffett on leverage
Responding to an investor who asked the Oracle of Omaha to explain his methods for reducing risk in Berkshire's portfolio, Buffett stated:
"If you talk about transforming events, or really talk about major events that could have huge consequences that are low probability, they're more likely to be in the financial arena than in the natural phenomena arena. But we'll think about them in both cases. But we do spend a lot of time thinking about things that can go wrong in a very big and very unexpected way."
He then went to explain why avoiding leverage is the best method for protecting against uncertainty:
"We just don't believe in a lot of leverage. I mean, you could have thought junk bonds were wonderful at 15% because they eventually did go to 6%, you would have made a lot of money.
But if you owed a lot of money against them in between, you know, you wouldn't have been around for the party at the end.
So we believe almost anything can happen in financial markets. And the only way smart people can get clobbered, really, is through leverage. If you can hold them, you have no real problems.
So we have a great aversion to leverage and we would predict that a very high percentage of the smart people operating in Wall Street, at one time or another, are likely to get clobbered through the use of leverage.
It's the one thing that forces you — it's the one thing that ends — or can prevent you from playing out your hand. And all of the hands we enter into look pretty good to us. But you do have to be able to play them out."
Prepare for the worst and hope for the best
It is impossible to tell when the current market crash will end. It is also going to be impossible to predict when the market will bottom. All investors can do in the current environment is sit tight, adding to positions when they're trading at a deep discount to intrinsic value.
You can't do this if you're using leverage, and companies that have a lot of borrowing are also exposed to more damages. When the dust has settled, there will be great opportunities, and the market will likely come back stronger.
If you've been kicked out of the market, or need to sell holdings at the bottom to cover margin calls, you could miss out on the recovery. The same goes for companies. Businesses with a lot of borrowing won't be able to capitalize on the opportunities that come out of the crisis.
Disclosure: The author owns shares in Berkshire Hathaway.
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