"Be fearful when others are greedy and greedy when others are fearful," said Warren Buffett (Trades, Portfolio) in a letter to Berkshire Hathaway Inc. (BRK.A, Financial) (BRK.B, Financial) shareholders in 2003. It has become one of his most well-known statements and one of the most repeated.
It certainly does nit sound like conventional wisdom. In fact, quite the opposite.
But this advice encapsulates the essence of contrarian investing, a strategy that has served Buffett well over his decades-long career. By resisting the urge to follow the herd and instead going against the grain, the Oracle of Omaha built his fortune and cemented his status as one of the greatest investors of all time.
Let's take a closer look at this famous Buffett maxim, examining both sides of the coin, so you can better understand what it means and why it is so important.
Being greedy when others are fearful
The first half of Buffett's advice instructs investors to get greedy when others are fearful. This means viewing market downturns, panics and general pessimism as opportunities to swoop in and buy when valuations are depressed.
Why does this work? Essentially, it takes advantage of the market's tendency to overreact. In times of uncertainty or distress, fear and panic take hold, causing indiscriminate selling and a rush for the exits. Quality assets get caught up in the frenzy and can be picked up for bargain prices by disciplined investors who keep their heads.
Buffett displayed this on numerous occasions throughout his career. Back in the 1960s, he made a substantial investment in American Express Co. (AXP, Financial) after the infamous "Salad Oil Scandal" caused the stock to tank 50%. Though the company suffered major losses from the fraud, Buffett analyzed its fundamental business model and saw the long-term stayed strong. His faith was rewarded with a five-fold return over the next five years.
Similarly, Buffett bought Coca-Cola Co. (KO, Financial) stock in 1988 during a market lull. While others were cautious, he recognized Coke as a high-quality company with unparalleled brand value. He appreciated its "wide moat" and bought in for the long haul. Berkshire Hathaway's position in Coca-Cola is now worth over $24 billion, delivering steady dividends year after year.
More recently, during the Great Recession of 2008-09, Buffett made big buys in companies like Goldman Sachs Group Securities STRATS Trust for Series 2006-2 (GJS, Financial) when fear erased stock prices. As usual, he kept his head, saw intrinsic value and seized the opportunity when it arose.
Key principles for investors
So what does this mean for you? Here are some key principles to keep in mind:
- Identify strong businesses with excellent fundamentals and staying power. Have them on your watchlist before trouble hits.
- Be patient and ready to act. Downturns and panics eventually arise. Prepare yourself financially and psychologically.
- Have the courage to buy when the herd is panicking. Block out the noise and stick to your valuations.
- Focus on the long-term business fundamentals, not short-term stock volatility. Have a multiyear investment horizon.
Adopting a greedy mindset when others are irrationally fearful requires inner resolve and conviction, but handsomely rewards those who can act decisively amidst the storm.
Being fearful when others are greedy
The flipside of Buffett's advice is to get fearful when others get greedy. This means exercising caution and resisting exuberance when optimism and valuations reach dangerous levels.
Why is this prudent? Because greed causes bubbles. When stocks rise, expectations run high and euphoria reigns; it is easy to get sucked into chasing momentum instead of focusing on underlying value. High fliers get bid up to crazy heights before ultimately crashing back down.
Buffett avoided getting caught up in the dot-com bubble of the late 1990s precisely because he stayed rational when the rest of the investing public clamored for the next hot tech stock. While others threw money at companies with no profits and dubious business models, the guru stuck to his principles.
Lessons for investors
Some key lessons here include:
- Recognize when overall market valuations are being stretched by greed and speculation rather than business fundamentals.
- Don't get infected by the herd's euphoria. Independent thinking is required. Make valuations your guide.
- Keep fear of missing out in check. The crowd is often wrong at turning points.
Playing it safe when greed takes over seems passive, but it is an essential trait of long-term success. Avoiding large losses enables compounding to work its magic. As Buffett preaches, the first rule of investing is "Don't lose money."
Contrarian investing in action
While simple in concept, contrarian investing takes steely resolve to execute in the real world. Fear and greed continually engage in a tug-of-war, and fighting these primal urges can be exhausting.
Here are some tips to put into practice:
- Make a plan when emotions are not running hot. Identify valuation targets that will prompt action. Create a watchlist of quality companies to buy on dips.
- Understand your circle of competence. Stick to businesses you understand to avoid impulsive decisions.
- Adopt a long-term mindset. Short-term noise should not impact long-term value.
- Remember that risks are lowest when fear peaks. Have cash on hand to deploy.
- Sell incrementally to avoid selling a winner too early. But trim positions as valuations get excessive.
- Ignore doomsayers and opportunists alike. Make valuations your north star.
- Focus on high-quality companies. The best businesses tend to recover and keep growing.
- Accept you'll never perfectly time tops and bottoms. Approximate, don't obsess.
By developing your emotional discipline and understanding of business fundamentals, you put yourself in a position to take advantage of others' excesses. That's how you rake the chips from the amateurs.
Buffett makes it look natural, but his level of conviction took decades to hone. Start building your skills now, so you can act like the Oracle himself when the next crisis or bubble hits.
The rewards of contrarian investing
Legendary investors like Buffett make contrarian investing look easy, but it takes continuous self-reflection, study and commitment.
When done right, however, it can lead to life-changing wealth creation. There's a reason he is one of the richest men alive.
Beyond the financial rewards, there is an element of self-mastery that comes from resisting crowd psychology and forging your own path. Marching to the beat of your own drum and basing choices on fundamental business facts rather than emotions is enormously empowering.
But like any high-level skill, it takes practice and patience. Start honing your ability to be greedy when others are fearful and fearful when others get greedy. With time, it will pay dividends.
