Warren Buffett: How to Invest in an Overvalued Market

Some people are not actually emotionally or psychologically fit to own stocks, but I think there are more of them that would be if you get educated on what you're really buying, which is part of a business. There is Mr. Warren Buffett, the world's best investor. He took over Berkshire Hathaway in 1965, and since then the stock has averaged 20% returns per year. That's double the return of the S&P 500 each year, which over time gives Berkshire a total return of 2.8 million percent versus the S&P's measly 23,000.

And he's done this by following a very simple set of rules that was summarized quite perfectly by Warren Buffett's long-time business partner and Berkshire Hathaway vice chairman Charlie Munger. We have to deal with things that we're capable of understanding. Then, once we're over that filter, we have to have a business with some intrinsic characteristics that give it a durable competitive advantage. And then, of course, we would vastly prefer a management in place with a lot of integrity and talent. Finally, no matter how wonderful it is, it's not worth an infinite price. So we have to have a price that makes sense and gives a margin of safety, considering the natural businessitudes of life.

It's a very simple set of ideas, and the reason that our ideas have not spread faster is that they're too simple. Charlie's right; it's a pretty simple four-step approach. I should mention at the top of the video that this approach never changes, no matter the weather in the market. So whether this video was titled "Buffett's Advice for 2022" or "Buffett's Advice for 1984," these four investing pillars would always remain the same.

But in 2022, there's no doubt we've got some tricky additional factors to negotiate with our investing. We're facing absurdly overvalued stock markets; inflation is running quite hot, and we're likely going to see some interest rate hikes this year because of that inflation. So in this video, let's listen to Warren Buffett's advice on each of these three key factors.

We start with the problem of overvalued stock markets. How do we go about investing this year when everything is so expensive? Well, if you're an active investor, chances are we might not actually get that many opportunities to buy undervalued stocks within our circle of competence this year. This is what Warren Buffett said on this matter back in 2019 in his annual letter to shareholders. He said, "In the years ahead, we hope to move much of our excess liquidity into businesses that Berkshire will permanently own. The immediate prospects for that, however, are not good; prices are sky-high for businesses possessing decent long-term prospects."

Now, yes, Buffett is trying to buy entire businesses while we're just trying to buy a few shares, but it's all the same thing at the end of the day. No doubt he has really struggled to find places to put his money in the past year or two. But he doesn't just burn his money on overvalued stocks, right? That is a cardinal sin of investing. Instead, he just continues to accumulate cash and he waits patiently. Berkshire Hathaway's cash pile has grown from $84.4 billion in Q3 2016 to $149.2 billion in Q3 2021.

So it's by no means ideal, but remember, you don't make money when you buy or sell; you make money while you wait. Be patient for those right opportunities to come along, and don't get sucked into buying average investments in a very overvalued market. Because remember, as Buffett says, you don't need that many great stocks in your whole lifetime. But three wonderful businesses is more than you need in this life to do very well.

How many times have we heard that from Buffett? You don't need that many wonderful investments in your life to do very well, so stay patient until the market eventually offers you one. That's the unfortunate reality of active investing in 2022. But there is another investing strategy out there that Buffett frequently recommends for most people, which is of course passive investing.

For passive investors that are simply dollar-cost averaging and participating in the stock market, they should definitely continue to invest in 2022. "The best single thing you could have done on March 11, 1942, when I bought my first stock, was just buy an index fund and never look at a headline. Never think about stocks anymore. Just like you would do if you bought a farm; you just buy the formula, let the tenant farmer run it for you."

I pointed out that if you'd put $10,000 in an index fund that reinvested dividends—... and I paused for a moment to let the audience try and guess how much it would amount to—it would come to $51 million. Now, I love that clip for the passive investor. It isn't about trying to invest at the perfect times. The nature of the dollar-cost averaging strategy is that you continue to buy market-tracking investments at the same time intervals, rain, hail, or shine.

By doing this over decades and decades, you will get the average return of the market. And by the way, it's about eight to ten percent per year. So I would pick a broad index, but I wouldn't toss a chunk in at any one time. I would do it over a period of time because the very nature of index funds is that you are saying, "I think America's business is going to do well over a reasonably long period of time but I don't know enough to pick the winners."

And I don't know enough to pick the winning times. There's nothing wrong with that. I don't know enough to pick the winning times. Occasionally, I think I know enough to pick a winner, but not very often. And I certainly can't pick winners by going down through the whole list and saying, "This is a winner, and this isn't," and so on. So the important thing to do if you have an overall feeling that businesses are a reasonable place to have your money over a long period of time is to invest over a long period of time and not make any bet implicitly by putting a big chunk in at a given time.

So for passive investors, as Warren was just saying, don't worry that the market is high or low. Just keep on going; never read a headline, never look at a chart. Just follow your strategy, have an ultra-long-term mindset, and the stock market is your friend. I mean, even if you invested everything and the market crashed 50% tomorrow, that's still not a disaster for long-term passive investors.

After the GFC—literally the world's worst financial crisis since the Great Depression—it only took five and a half years to be back where you were, and nine years on, the market has nearly tripled itself from that point. So yes, the market is high right now, but that's not the end of the world. As active investors, we need to stay patient and not do anything silly. And as passive investors, we need to continue on as we always have—just keep gunning for that average.

But next up, what about inflation? That's been a big story over the past 12 months, and rightly so. We're up to 6.8% annual inflation in the US, and it's looking likely that inflation will be a big story going into 2022 as well. It's a fascinating time. We've never really seen what shoveling money in on the basis that we're doing it on a fiscal basis while following a monetary policy of something close to zero interest rates.

It is enormously pleasant, but in economics, there's one thing always to remember—you can never do one thing; you always have to say, "And then what?" That was Warren speaking back in May 2021, before inflation had really taken off. You can tell he saw inflation coming, can't you? It's exactly as Buffett said: In economics, you can't just do one thing; you have to ask, "And then what?"

What do you know? The zero interest rates and the money printing finally caught up with us. Inflation is running hot. So Mr. Buffett, what do we do about it? Well, Buffett's actually explained this one a long, long time ago. We're going back to 1982, a time when U.S. inflation was just cooling down after it had risen to about 20%. In 1982, Buffett wrote in his annual letter to shareholders exactly what sort of businesses we should be buying during inflationary periods. He said, "Such favored businesses must have two characteristics. One, an ability to increase prices rather easily, even when product demand is flat and capacity is not fully utilized, without fear of significant loss of either market share or unit volume. And two, an ability to accommodate large dollar volume increases in business often produced more by inflation than real growth, with only minor additional investment of capital."

So number one, he's talking about businesses that have the ability to increase prices and cop no consequences. That definitely helps to counter the effects of inflation. But what business could raise prices substantially and not lose market share? Surely people would look for some sort of cheaper product elsewhere. Well, not if you have a moat, not if you have a competitive advantage. Apple raises their prices higher than the competition all the time—no consequences to their market share. Coca-Cola raises their prices; people don't switch to the other drinks.

And funnily enough, they're two of Warren Buffett's biggest investments right now. The single most important thing to do during periods of inflation is to ensure the companies you're looking at have a competitive advantage—something that means they will keep their customers and thus their market share even if they raise prices.

Then secondly, Buffett says we need to look for businesses that can accommodate a large dollar volume increase in business with only minor additional investment of capital. Essentially, companies that are able to generate a lot more cash without needing to spend a lot to make that happen. So this just means you need to look at the companies that have very scalable business models. You know, Facebook doesn't need to build another app just to make more ad revenue; they can just increase the frequency of their ads.

Whereas if Ford wants to double their revenue, they need to build new factories or hire more employees to make more cars. That's a much harder task. So in times of inflation, look for that competitive advantage and also look for companies that are easily scalable.

Then lastly, let's talk about interest rates. The Fed has announced they're thinking about three interest rate hikes in 2022. What does Buffett have to say about interest rates? "Interest rates, you know, basically are to the value of assets what gravity is to matter, you know essentially." On Thursday, the U.S. Treasury sold some four-week notes—Treasury bills—it says average price $100.0000000. The Treasury received the money at zero.

So you've had this incredible reduction in the so-called super-risk-free group—the short-term Treasury bill—and that is the yardstick against which other values are measured. I mean, if I could reduce gravity's pull by about 80%, I'd be in the Tokyo Olympics jumping. Essentially, if interest rates were 10%, valuations are much lower, so you've had this incredible change in the valuation of everything that produces money.

Because the risk-free rate produces really short enough right now—nothing! So that is another clip from the shareholder meeting in May 2021, and it explains exactly why the market is so high right now. Because interest rates are at zero, the big money managers are simply not getting a return in bonds. So the money they would normally have in bonds finds its way into the stock market to chase returns, and that pushes up valuations.

That's the dynamic that Buffett was talking about: Interest rates are to stock market valuations what gravity is to matter. The lower the gravity, the easier it is to jump. But if you increase gravity, it's much harder—same thing with the stock market right now. We're seeing ultra-low interest rates, which means stock market valuations rise very easily.

There's a lot of money flowing into the market, but in 2022, we're about to start going in the other direction. Interest rates are going to start rising, and the higher interest rates rise, the stronger gravity is pulled, the harder it is to jump. So while you should never let the macroeconomic environment impact your own personal investing, it's just worth noting that in 2022, 2023, and so on, we might see valuations come under pressure, particularly for overvalued stocks as new bonds get more enticing and interest rates rise.

So no doomsday prediction, but just know that that is a possibility across the next few years, so be ready for it. And that, my friends, is a selection of Warren Buffett's advice, which will hopefully help us with the big investing challenges of 2022. Hope you enjoyed this video, and if you did find it useful, please leave a like on the video. This supports the video greatly in the YouTube algorithm, and it really does help the channel to grow.

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