Why Warren Buffett loves a stock market crash

Warren Buffett sees a stock market crash as a golden opportunity to top up his holdings.

“Bad news is an investor’s friend” according to Warren Buffett, one of the world’s richest and oldest investors. He’s built his wealth, currently estimated at over $100 billion, over the last 80 years: a period that has seen many stock market crashes including Black Monday, the Dot-com bubble and the financial crash in 2008.

And one of Buffett’s main investing tools is to know how to take advantage of a stock market crash.

In a 2016 letter to shareholders, Buffett said: “When downpours of that sort (stock market slumps) occur, it’s imperative that we rush outdoors carrying washtubs, not teaspoons. And that we will do.”

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In the long run, knowing how to benefit from a market downturn is the one of the best ways to build investing wealth. It’s where it often pays to put on your hard hat, block out the noise and remember your long-term strategy.

Ignoring investor sentiment

Like Buffett, we all know that it’s important to buy stocks when they’re cheap. But when there is a stock market crash, bargain hunters are often surprisingly thin on the ground.

It’s strange because, when we’re shopping, we automatically know how to find a bargain. Whoever heard of someone rushing to DFS because furniture prices are higher than ever? I don’t think so!

But when it comes to stock market investing, somehow our bargain-hunting instincts often desert us. Many investors pile in and buy when prices are rising and lose their confidence and sell when prices fall.

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In contrast, we should take some lessons from Buffett, who said that: “Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”

Quality over quantity

But it’s important not to buy any old junk when the market takes a tumble. Buffett concentrates on buying “quality” stocks during a market correction: that means companies that are highly profitable and have a proven track record.

Buffett’s ability to stick to a long-term strategy is remarkable. His investment company, Berkshire Hathaway Inc Class B (NYSE:BRK.B) has around 75% of its portfolio invested in only five companies: Apple Inc (NASDAQ:AAPL), Bank of America Corp (NYSE:BAC), Coca-Cola HBC AG (LSE:CCH), Chevron Corp (NYSE:CVX), and American Express Co (NYSE:AXP).  A stock market crash is a good chance for Buffett to top up his holdings but not to go crazy and start buying companies he doesn’t believe in.

Stick to what you know

As well as buying quality stocks,Buffett is well known for only investing in companies he understands. He avoided tech stocks until long after dot.com bubble burst in the early 2000s. He emerged from the crash relatively unscathed and only began buying Apple stock in 2016, once the company had proved itself as a market leader.

Just as he rejected tech-stocks; Buffett counsels other investors to stay within their “circle of competence” and stick to stocks and companies they understand and believe in.

According to Buffett, for many investors, that could mean opting a simple low-cost fund that tracks the whole market. There might be less stellar returns than picking the right stocks, but there’s also less risk of failure as you’ll spread your risk between hundreds of companies.

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Speaking about a simple investing approach, he famously contrasted investing with diving: "In Olympic diving, you know, they have a degree of difficulty factor. And if you can do some very difficult dive, the payoff is greater if you do it well than if you do some very simple dive. That’s not true in investments. You get paid just as well for the most simple dive, as long as you execute it all right. And there’s no reason to try those three-and-a-halfs when you get paid just as well for just diving off the side of the pool and going in cleanly."

When it comes to investing, it’s often the simplest investing ideas that have the biggest pay-off.

Spotting a bargain

Investing when the stock market is down is a good chance to bag a bargain.

Over the last 50 years there are scores of examples of the stock market bouncing back from a crash. Between 1986 and 2022 there have been nine years where the FTSE All Share Total Return index, which includes dividends, posted a negative return, compared with 28 years with a positive return. Someone who invested £10,000 in the FTSE All Share in 1986 would have seen that small pot grow to £234,000 by the end of May 2022.

And even though those soaring returns may be behind us, there are still plenty of potential bargains. The FTSE 100 hit a record high just last month, but the index, which is packed with banks and financial stocks, has been upended by the recent collapse of America’s SVB Financial Group (NASDAQ:SIVB) and problems at Credit Suisse Group AG (SIX:CSGN). It is currently down almost 700 points, or 8.4% from the 16 February high at 8,047. The UK-dominated FTSE 250 has fallen from 20,614 in early February to just 18,612 currently, a drop of 9.7%. Smaller companies were hammered last year and remain vulnerable in 2023.

Latest problems to hamper markets add to concerns around the war in Ukraine, high inflation, rising interest rates, a cost-of-living crisis, geopolitical issues and any number of other potential banana skins. But, as was demonstrated by the stock market rally between October and February, stellar growth could return in the future if headwinds begin to lift.

Over the pond, many of the big American companies have so far failed to regain losses suffered in 2022. That could be another great buying opportunity.

Of course, the past is the past, and eye-watering returns are not guaranteed in the future. However, they do remind us that it often pays off to be brave and buy when prices are down.

Dollar cost averaging

In order to really take advantage of a stock market crash we need to have piles of cash sitting around waiting to invest. That might be fine if you’re super-rich but it’s unachievable for most of us.

But the good news is that, for most investors, Buffett advocates sticking to regular investing to build your investment wealth.  Regular investing means you won’t be tempted to buy when the market is high but instead and can benefit from “dollar-cost averaging”, buying at every point during the stock market cycle.

To quote Buffett again, “if you like spending six to eight hours per week working on investments, do it. if you don't, then dollar-cost average into index funds.”

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And as for his legacy, Buffett has the simplest of possible strategies for his wife’s retirement trust when he dies. He revealed in a letter to the Berkshire Hathaway shareholder that he has instructed his trustees to, “Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors—whether pension funds, institutions, or individuals—who employ high-fee managers.”