Warren Buffett's Tips to Prepare for a Stock Market Crash

Now, I'm not a doomsday predictor. I've never tried to time the market, and honestly, I never will. That's a fool's errand. But it's no secret that right now, markets are high, and sooner or later, we'll see another bear market or a full-blown stock market crash. It's just inevitable. And hey, it's good to be prepared.

So, in this video, we're going to have a look at a few principles that Warren Buffett himself is implementing right now that will ensure in the event of a stock market crash, we come out in a much better financial position than where we are now.

Now, Warren Buffett is most certainly not in the business of making market predictions. So you won't find interviews of him discussing how he's preparing for an upcoming market crash. But we can read between the lines a little bit because what we do know is that both he and Charlie Munger feel we are in a period of excessive speculation. So instead of listening to him speak, let's dive into the moves Buffett is currently making and the principles he's following that will protect him from rough times ahead.

The first big thing that Buffett is doing is he's keeping a lot of cash on the sidelines. So Berkshire Hathaway currently holds 142 billion dollars in cash or short-term treasuries. For context, they did 6.8 billion in free cash flow for last quarter, so that's about five years' worth of accumulated free cash flow just sitting there in the war chest. For even more context, Apple, one of the world's largest companies, only has 70 billion dollars in cash and short-term securities. So Buffett really is keeping a fair portion of his cash on the sidelines right now. I mean, his stock portfolio is worth 270 billion dollars, and he holds 142 billion dollars in cash; so he's sitting at about 34% cash.

Although technically that's not really the fairest way to represent it, because of course a lot of that cash is necessary for the safety of Berkshire's actual business operations. So why is Buffett keeping so much on the sidelines? Well, of course, it's because of the current state of the economy and the current state of the stock market.

Number one, Buffett has come out and said that he feels he needs a lot of that 142 billion to protect Berkshire's businesses in a worst-case scenario, which that in itself is a bit of a hint for investors. But the second reason he holds so much cash is just a function of his investment strategy. He's not trying to hold all that cash; in fact, Buffett would much rather do the opposite. He'd rather have his money invested in high-quality businesses. But Buffett will never be caught willingly paying too much to own a piece of a business. He just won't do it, and because almost every business right now is overvalued, that means he isn't buying much, and naturally, he's going to accumulate more cash.

This is certainly a big point we can take from Buffett to help us prepare for a market downturn: simply have some cash in the war chest to be able to snap up bargains if they present.

Then another thing we can learn from Buffett to protect us in the event of a market crash is to avoid margin debt. So margin loans are simply when you borrow money to make investments. However, if you have a lot of money invested on margin and your stocks fall, you may be forced to meet a margin call, and if you can't pay up, you'll be forced—yes, forced—to sell your investments and take a big loss.

Now, Warren Buffett has always been against margin loans. This isn't just like a right now kind of thing, but it is particularly important to focus on eliminating margin loans if the market is very overvalued. Why? Because really overvalued stocks can fall back down to earth very, very fast, and that can easily trigger a big fat margin call. This is Warren Buffett discussing margin loans just a few years ago:

"Four times in the 53 years I've been at Berkshire, the stock has gone down anywhere from 40 to 60 percent. Berkshire shares just—and sometimes well—very fast. In October of 1987, people had a perfectly decent investment if they borrowed against it; they lose it. I—it's crazy in my view to borrow money on securities. You do not know tomorrow morning—you don't know whether the stock exchange will open tomorrow morning. I mean, we have closed the stock exchange one time during World War One; we closed it for months. We closed it after 9/11 for a few days. It's insane to risk what you have and need for something you don't really need.

And you know, borrowing money is a way of trying to get rich a little faster, but there are plenty of good ways to get rich slowly, and you can have a lot of fun while you're getting rich as well."

There you go, and he's absolutely right. You know, margin is a way to try and amplify your returns, but it comes with great risk. And guess what, as I said before, if that margin loan is invested in stocks that are currently way overvalued, then that risk is even higher. You know, even just the stock price reverting back to its fair intrinsic value—you know, where it should be—that could be enough of a dip to force you to sell and take a big loss on a business that's actually really great.

So, takeaway: reduce margin debt. Kick it; you know, get rid of it, and your wife and kids will thank you if the market plummets anytime soon.

All right, next lesson, Mr. Buffett. How can we prepare for a potential upcoming market crash? Well, one thing we can definitely learn from Warren Buffett is to avoid being sucked into speculative investments just to chase decent returns, and this is particularly sound advice right now.

So when the market rises as much as it has, and money is being thrown at stocks left, right, and center, it starts becoming very difficult to make good returns by just investing in solid, stable, healthy cash flow, high-quality businesses; they're all just really expensive. So much so that prices just don't make sense—the numbers don't work out. So typically what happens is money starts flooding into riskier and riskier asset classes as investors chase returns elsewhere. This is something that Buffett has never done, and typically the riskier the asset, the more it will get punished in a market crash.

Yes, all assets will get crunched if the market just falls off a cliff, but think about it like this: if a company has a great moat, great management, consistent growth in cash flows, you know, over the past decade, well, investors will have much more faith in that company as the market falls than say a non-cash producing asset that is simply worth what the next person is willing to pay for it.

A good example of an asset like this is cryptocurrency. And this is Warren Buffett discussing why he'd personally never invest in a speculative asset class like this:

"When you buy a farm, you look at the crop every year and what prices are, and you decide whether it was a satisfactory investment. I mean, you look to the asset itself and what it produces for you. When we buy a business, we look at what the business earns and decide how we feel about it in terms of what we paid. But we are buying something that at the end of the period we not only have what we bought in the first place, but we have something that the asset produced. And when you buy non-productive assets, all you're counting on is whether the next person is going to pay you more because they're even more excited about another next person coming along. But the asset itself is creating nothing."

That makes total sense, and you know in a market crunch the added uncertainty around assets that are non-productive means that very often they get crunched much harder than anything else.

And that previous clip is kind of foreshadowing to the last point we can take from Buffett in order to prepare for a market crash, and that is quite simply to ensure your portfolio is comprised only of high-quality businesses. This is the single best way to be prepared for a market crash. Make sure that if and when your portfolio drops by 30%, the businesses that sit in that portfolio are just great businesses.

And what I mean by high quality are really three main factors: one, they have a competitive advantage; two, the management team is competent; and three, the business is simple enough that you can understand it well.

So why is this the best protection in the case of a market crash? Well, there are a few reasons here. Number one, in tough times, great businesses that are managed well have low debt and solid cash flows. They are unlikely to go bankrupt. It's unlikely your investment is going to go to zero.

Secondly, if your portfolio sinks and you just hold high-quality businesses, you won't have to freak out and decide whether you need to sell your stocks or not. I mean, you can just hold them; they're great businesses. So you know once everybody else is done freaking out about the price to put on the stock in the short term, the price should revert back to something that reflects the underlying business performance, which is fine.

Then number three, if you hold high-quality businesses and then your portfolio crashes, well, that presents you with a very handy but infrequent opportunity where you can buy ten dollar bills for five dollars. You know you've done your research; you know those companies are strong; you know what they're worth. So in reality, you should be pumped up about the opportunity to buy them at such discounted prices.

Remember what Warren Buffett said: the stock market is the only place where investors run out of the store during a sale. So don't be that guy.

Warren Buffett has led by example on this last point as well. He has monster positions in Apple, Bank of America, American Express, Coca-Cola, and he's held these positions for many years—in a lot of cases, decades. But you know, when the market crashed in 2000, or 2008, or March last year, he didn't freak out and sell these stocks just because the prices were heading south.

Buffett knows these businesses; he knows they're operating well, so he simply holds them, or you know, in a lot of cases, he buys more. The best protection for his portfolio is knowing that he holds great businesses that will just do very well in the long run.

So anyway, they are the four key lessons we can take from Buffett in order to set ourselves up for a potential market crash. Again, it is not smart to try and time the market, but there are definitely a few good principles that we can take away from what Warren Buffett does to make sure that we're set up in case something does happen.

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