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Robert Stephens, CFA
Robert Stephens, CFA
Articles (413) 

Warren Buffett: Don't Dance to the Tune of Speculation

A margin of safety and a long-term view may be more appropriate

November 24, 2020 | About:

The S&P 500's 10% rise this month on top of its bull run since the end of March means that many investors will have made profits on their holdings in the index in recent weeks. This may make them feel more optimistic about the stock market's future. It could even tempt them to buy stocks now, and seek to sell them for a profit over a short space of time.

In my opinion, that is a dangerous strategy to use when seeking to allocate capital efficiently. It goes against the advice of value investors such as Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) chairman Warren Buffett (Trades, Portfolio).

The problem with speculation

In my view, speculating on stock prices has two major flaws. First, no bull market has ever lasted forever. Therefore, all investment carries with it the risk of losing money in the short run. For a long-term investor, short-term losses are unlikely to be a major concern because they are more interested in how their portfolio performs over a multi-year timeframe. However, short-term investors, or speculators, may need to sell out of loss-making positions.

The second major flaw with speculating, in my opinion, is that it is impossible to know when a bull market will come to an end. Evidence of this can be seen in the early 2020 Covid-19 market crash. It took place over five weeks, with the S&P 500 declining 34% in that time. There was no prior warning that it would take place. Therefore, speculators are likely to have made considerable losses in a very short period of time.

Buffett's letter to shareholders

These two flaws were discussed in Warren Buffett (Trades, Portfolio)'s letter to Berkshire Hathaway shareholders in 2000. To put the letter into context, the stock market was part-way through its early 2000s bear market when it was written. Buffett wrote the following:

"The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities - that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future - will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There's a problem, though: They are dancing in a room in which the clocks have no hands".

A margin of safety

As well as using a long-term approach when investing, seeking a margin of safety can guard against the ill-effects of speculation. Requiring a margin of safety when purchasing any stock is likely to mean you avoid overvalued companies that may be hit hardest in a subsequent bear market. For instance, in today's market it may mean that you dodge richly-valued stocks that have optimistic forecasts. Instead, you may purchase undervalued stocks that are currently less popular among investors.

This strategy may mean missing out on short-term capital growth if the market moves higher following recent gains. However, it could lead to a more efficient capital allocation over the long run.

Disclosure: The author has no position in any stocks mentioned.

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