Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) chairman Warren Buffett (Trades, Portfolio) has consistently been able to avoid the market mania associated with bull markets during his career. This has allowed him to avoid overvalued stocks and instead capitalize on lower valuations during the bear markets that have always followed bull runs. As he once said:
“Don't get caught up with what other people are doing. Being a contrarian isn't the key but being a crowd follower isn't either. You need to detach yourself emotionally.”
Of course, following his lead is easier in theory than it is in practice. Indeed, the stock market’s 100% return since its March 2020 low is close to the average rise of 112% during previous bull markets. However, it has taken place over a period of around 18 months versus an average bull market length of approximately three years.
As such, many investors have experienced rapid returns over recent months. Evidence that recent gains are causing investors to become highly optimistic can be seen in the VIX, which measures fear levels and is currently lower than its pre-pandemic reading, and in today’s company valuations, which in many cases can only be justified via extremely upbeat earnings forecasts.
A disciplined approach
In my view, the importance of following Warren Buffett (Trades, Portfolio)’s advice in remaining level-headed during market extremes should not be underestimated. It can help any investor to avoid paying more than a stock’s intrinsic value. Doing so could help to avoid large losses in the next bear market, since today’s overvalued shares could be hit hardest by future market declines. It may also mean an investor has capital available should stock valuations fall to more attractive levels.
One way of avoiding bull market mania in favor of a disciplined approach is to rely on fundamentals rather than emotions. For example, this could mean using figures such as a stock’s valuation versus its peers and compared to its long-term average. It may also include assessing the financial strength of a business and analyzing ratios such as its return on equity and return on invested capital to deduce its investment appeal.
Certainly, some qualitative factors are required when deciding how to apportion capital. For instance, assessing the size of a company’s economic moat or competitive advantage versus peers requires a subjective judgment. As such, an investment checklist could be useful in instilling a sense of structure when deciding where to invest. It could force an investor to check specific areas or factors before making a decision. This may make them less likely to rely on emotions when managing their portfolio.
A lonely experience
Of course, being detached from the crowd can be a lonely experience, especially in the short run. The stock market’s recent rise could continue over the coming months. Investors who avoid today’s overvalued shares could miss out on strong gains while their peers become increasingly overjoyed at their portfolio gains.
However, the track record of the stock market shows that bear markets inevitably follow bull markets. Buffett’s strategy of relying on facts and figures could prove useful in shifting the emphasis from seeking approval among peers to using fundamentals when apportioning capital over the long run. As he once said, “You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.”
