The S&P 500 has gained 40% since reaching its three-year low in March. Investors have become increasingly bullish as they have focused on the prospect for a reopening of the economy rather than high unemployment levels and the potential for a recession.
However, stock market sentiment can quickly change. Therefore, investors may wonder whether now is the right time to buy stocks or avoid them.
There is no clear answer to this qusetion, but by following the advice of experienced investors such as Warren Buffett (Trades, Portfolio), Peter Lynch and Howard Marks (Trades, Portfolio), it may be possible to gain insight into how to effectively allocate your capital.
A margin of safety
Trying to predict the future performance of the stock market is impossible.There are a huge range of variables that can impact stock prices, such as investor sentiment, macro factors, economic data and company performance.
Therefore, acknowledging the inherent challenges of trying to predict the future and instead obtaining a margin of safety when you buy stocks could be a more prudent approach. A margin of safety provides a "buffer zone" in case the future turns out to relatively disappointing.
Berkshire Hathaway BRK.A BRK.B chairman Warren Buffett (Trades, Portfolio) has often discussed the benefits of seeking a margin of safety when purchasing stocks. The Oracle of Omaha once said:
“We insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we're not interested in buying. We believe this margin of safety principle to be the cornerstone of investment success.”
Focusing on fundamentals
It is tempting to focus on a company’s recent stock price movements when deciding whether to invest in it. For example, investors may consider a stock to be in a good position to deliver capital growth due to its recent gains.
However, a company’s fundamentals may be a better means of determining its investment appeal. Factors such as the amount of leverage and the size of the economic moat can provide guidance as to its future financial prospects and, subsequently, its stock price performance.
At the moment, it may be more important than ever to buy stocks with solid fundamentals. They offer less risk than their weaker sector peers and could better capitalize on opportunities to grow their market positions.
As Peter Lynch once said, "This is one of the keys to successful investing: focus on the companies, not on the stocks.”
Past performance
The past performance of the stock market shows that it has never experienced a permanent bull or bear market. Therefore, it will eventually switch from one to the other, and vice versa.
However, trying to time when this switch will occur is a difficult process that is not always prompted by the valuations on offer. For instance, a stock market can be vastly overvalued but take a long period of time to commence its decline.
Therefore, apportioning your capital to the most attractive businesses and holding them for the long run could be the most logical approach. Otherwise, you may sell too early into a bull market or buy too early in a bear market.
Oaktree Capital co-founder Howard Marks (Trades, Portfolio) once highlighted that a fast-rising stock market does not necessarily mean that price falls are ahead: “Things can be overpriced and stay that way for a long time . . . or become far more so.”
Disclosure: The author has no position in any stocks mentioned.
Read more here:
- Benjamin Graham on Risk Versus Reward
- Seth Klarman on Seeking Value in a Rising Market
- Charlie Munger on Maximizing Your Returns in a Volatile Market
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