Profiting From Market Crashes

How 3 of the best investors profit from market crashes

We are currently in a stock market correction. Many investors enjoy hypothesizing about what the future holds for the stock market. Instead, they should be buying great companies for cheap. Let's look at what 3 great investors would do during these turbulent times.

There are many psychological reasons the market makes mistakes when the market goes down, as I’ve written about previously. Rather than fighting our inbred psychology, how can we try and re-frame our mindset so we can sleep better? We can start by learning a few simple lessons from some of the most talented investors of all time:

• Peter Lynch

• Mohnish Pabrai

• Warren Buffet

Peter Lynch

In Beating The Street he described a few interesting things after the crash of 1987: “In 39 out of 40 stock market corrections in modern history, I would’ve sold all my stocks and been sorry.” I also liked “A decline in stocks is not a surprising event, it’s a recurring event.”

His emphasis was obvious. Stocks go up and down in price at regular intervals. There’s no point in trying to fight this fact. It will happen if you are in the market. Guaranteed. If you plan on investing, try to imagine your favorite stock going down 50% or more. Get a feel for how that makes you feel. If you have a better awareness of this inevitability, it will soften the blow when it happens!

Note how Peter said he would’ve been sorry nearly every time there was a crash if he had sold his stocks during a correction. The reason for this is simple. After every correction, the stock market goes back to its previous high. This can take a short time or a long time and will proceed to crush this number over a long period.

Knowing this, you need to fight the urge to sell when you’re exposed to negativity. Selling while in a negative emotional state directly affects your rate of return. There will always be a recession around the corner, just like there will always be another bull run around the corner. If you can withstand the inevitable downswings, you should stay invested to take advantage of upswings. Trying to time corrections and upswing is a futile endeavor for pretty much

Mohnish Pabrai

Mohnish Pabrai gets asked regularly how to think and act during market downturns. He’s been through the tech bubble and the Great Financial Crisis (GFC). So he’s definitely been around for some rough times. Here are a few nuggets he mentioned in a recent interview:

• Losing 50% of your net worth should be irrelevant long-term if you know what it’s worth

• What something is worth is different than the valuation the market puts on it.

• The price range of a stock over 52 weeks is wide in auction-driven markets. So you can expect auction-driven markets to overshoot and undershoot.

This strikes me as being rational about our assets. Investing is an intellectual pursuit, where you use your brain to generate returns. It doesn’t matter what other people or the market thinks. As long as you are correct about your hypothesis, what the other people and the market thinks about your idea is irrelevant. Sure, you should be looking for events happening that are directly affecting your thesis. But just because the market goes down 20% plus, does not mean your stock is less valuable.

If you can try and filter out as much noise as possible, I think you’ll do well holding to your best ideas. This is assuming you did the right work from the beginning. Quick example. You do your analysis on a company and you buy it at $15, thinking in the next decade it has a very good chance of going to $120.00. If you’re like me, you like a huge margin of safety, so I’ll often cut the target in half, then discount back from there. So we think it will be worth a minimum of $60 ($120 / 2 = $60) in a decade. We apply our rate of return as the discount rate, I like 15%, and we get to around $15.

So we have a high degree of certainty that we will make 15% on our investment if we purchase at $15. So rationally speaking, why would we be upset if we can then purchase more at $12, $10, $8, etc? When we buy at lower prices we lower our cost basis. Let’s say we initially buy 1000 shares at $15. Our cost basis is $15 dollars per share. It drops to $10, we have some cash left for an opportunity just like this. We can then buy 1000 shares at $10 for $10,000.

Our cost basis has gone from $15 down to $12.50. Our rate of return goes from 15% to 17%. It’s a pretty easy decision when you look at it that way, isn’t it? Focus on the long-term prospects of your companies. What happens in the next 90 days is mostly irrelevant, so try and look past the stock price, and focus on the fundamentals of your businesses.

Warren Buffett

“Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble.” - Warren Buffett. This goes hand in hand with what I just wrote above. If you know the price of an asset, and it drops, you should be picking up troves of cheap shares.

You can invest in a bunch of different ways. You can buy all your shares at once, maxing the size of your investment with no plan to add to it at a later date. Some people like me, like to go with a 3-6% initial investment. I’ll then hope that prices go down and then add more as long as the price is below my initial price.

It can be easy to be myopic about investing. Most people go into an investment thinking as soon as they buy it, it will never go down in price. In reality, this isn’t how things work. The more time you spend in the markets, the quicker you’ll learn this. What ends up happening is you’ll have partial position sizes that run away from you to the upside. Perhaps you'll never get a chance to add to it. Then you’ll have other positions where you may have years where the price doesn’t move or goes down. This gives you the ability to increase returns by decreasing your cost basis.

The other part of the quote that I find powerful, is that you should have some cash on the sidelines at all times. During times when the market goes down, having cash is very beneficial. Using it to add to current positions or initiate new ones can be very beneficial and good for your wealth.

As the example I gave shows, when you can lower your costs basis, you get increased returns. The more you buy at cheaper prices, the lower your cost basis goes and the higher your returns go! This is what Buffett means that you should be bringing out the bucket and not the thimble. Let’s say in the same example, we have even more money on the sidelines and buy 2000 shares at $10 instead of $1000. Our cost basis is no $11.67. And our return goes up to ~18%.

Conclusion

You now have useable ways to help you make better decisions during these times of uncertainty. Heed this advice, and you’ll be well on your way to increasing your wealth. Fail to heed these concepts you’ll be stuck making poor decisions. Poor decisions will lower returns or even cause you to lose money. The choice is yours!