Warren Buffett: How to Make Money During a Recession

So it seems like pretty much everyone is worried about the economy right now, and for good reason. Inflation is at a multi-generational high. The last time inflation was this high in the United States was in 1981, more than four decades ago. In order to get this inflation under control, the FED is raising interest rates at an unprecedented clip, causing many people to believe that there is no possible alternative than for the economy to enter into a nasty recession. The economy is already starting to feel the impact of this combination of high inflation and rising interest rates. Companies are hiring less people than ever before. The unemployment rate has started to tick up. People are spending less on non-essentials. To sum it up, people and businesses are worried about what is coming.

Just look at this chart of the number of searches for the word recession on Google; it has spiked as people are trying to figure out how to prepare for what is ahead. In order to learn about how we should be investing and preparing for a recession, it makes sense to turn to investing legend Warren Buffett. At 92 years old, he knows a thing or two about recessions, especially considering he has lived through 18 of them since he was born. Let's see what Buffett had to say about how you should be investing during uncertain times like we're living through today.

But first, make sure to like this video and subscribe to the channel, because it's my goal to make you a better investor by studying the world's greatest investors. Now let's get into the video.

Well, I would say that at any given point in history, including when stocks were their cheapest, you could find an equally impressive number of negative factors. I mean, you could have sat down in 1974 when stocks were screaming bargains, and you could have written down all kinds of things that would have caused you to say, you know, the future is just going to be terrible. Similarly, at the top, you know, anytime you can write down a large list of things that would be quite on the bullish side. We don't panic; we really don't pay any attention to that sort of thing.

I mean, we have, you might say that our underlying premise—and I think it's a pretty sound underlying premise—is that this country will do very well, and in particular, it will do well for business. Businesses have done very well. You know, the Dow went from 66 to 10,000 plus in the hundred years of the 20th century. We had two world wars, nuclear bombs, flu epidemics, you name it, cold war. There's always problems in the future. There are always opportunities in the future, and in this country, the opportunities have won out over the problems over time. I think they will continue to do so, absent the weapons of mass destruction, which is another question. Business won't make much difference if anything really drastic happens along that line.

So we don't, I don't—I can't remember any discussions, Charlie, that I have had ever going back to 1959, where we would have come to the conclusion at the end of them that we would have passed on a great business opportunity, a business to buy, because of external conditions. Nor did we ever buy anything we thought was mediocre simply because we thought that the world was going to be wonderful at the… it won't be. The American economy, in my view, will reward investors over a 5, 10, or 20-year period. It will be the investors themselves.

If you look at the record of the 20th century, you'd say, how can anybody have missed owning equities during that time? And yet, you know, we had all kinds of people wiped out, you know, in the 1929-1932 period. We had all kinds of things that were bad. But if you would just own stocks right straight through, and didn't leverage them, you know, you would have gotten a perfectly decent return. So we were unaffected, in essence, by the variables you mentioned. Just show us a good business tomorrow and we'll jump at the hook.

So Warren Buffett's advice definitely contradicts conventional investing wisdom, and to Buffett's credit, you don't become as successful and wealthy as him by following that so-called conventional wisdom. Most people's investment strategy goes something like this: they try to predict what the economy is going to be like for the next 12 to 18 months, and then they decide what to invest in based on that. If they think the economy is going to be strong, they will want to buy a lot of stocks, or if they think the economy is going to be weak or enter a recession, they sell their stocks. This is obviously a generalization on my end to demonstrate a point, but honestly, it's pretty darn accurate. Just turn on the TV and turn to a business news program or open up YouTube, and you will hear this kind of message.

However, this approach of making investment decisions based on economic predictions is fundamentally flawed. There are two big reasons why, if you follow it, you will probably lose money. The first has to do with why you shouldn't factor in economic predictions into your investing strategy. According to Buffett himself, for something to factor into your investment process, it has to pass a very simple two-step test. That information has to be, number one, important, and number two, knowable.

Or put it another way, that information has to be important enough that it will impact your investments, but also has to be something that you can know or predict with relatively high amounts of accuracy. The first point—economic predictions—definitely meet the criteria of being important. It would be very helpful to know what the future of the economy holds, and it would be great if you knew when exactly the economy would tank. You could sell home building and auto stocks right before the economy entered a deep recession and people stopped buying houses and cars. You could then buy those stocks right before the economy took off again and recovered, and those same companies started making a ton of money. You would make quite a bit of money this way, and it wouldn't be long before you were a billionaire and an investing legend.

Of course, what's going to happen to the economy is important when it comes to investing, so it clearly passes the first part of Buffett's two-part test. However, where economic predictions fail the test is on point number two—being knowable. It's impossible to accurately and reliably predict what's going to happen in the economy. Buffett is approaching 100 years of age, and in his own words, he has never met someone who can accurately predict the economy. Keep in mind, this is despite the large number of people who claim to be able to do so.

The reason the economy is so difficult to predict is because it's so complex. Most people view the economy as if it were a simple equation, something like X plus Y equals Z. In actuality, though, the economy acts more like a complicated calculus equation with thousands of variables. All of these variables impact each other, especially as economies become more and more global and intertwined.

This is why economic events in one country can impact economic events all across the globe. We have seen that dynamic in action over the past couple of years. This dynamic causes predictions about the future of the economy to be unknowable. As a result, economic predictions fail the second part of Buffett's simple test of whether a particular piece of information should be factored into your investment decisions. The fact that the future of the economy is unknowable is one reason why it's nearly impossible to make money investing based on economic predictions.

However, there's another big reason. Usually when the economic outlook is brightest, that is when stocks are most expensive. So if someone only wants to own stocks when the economic outlook is good, they're going to be paying a lot of money for those stocks. The more expensive stocks are when you buy them, the lower your future returns will be. The opposite is also true: the cheaper stocks are when you buy them, the higher your future returns will likely be.

When the economic outlook is negative and people are worried about the economy, people tend to sell their stocks, and as a result, stock prices are usually cheaper. Take a look at this diagram from legendary investor Howard Marks. This diagram shows how the stock market acts. The black line is the movement and price of the stock market, with each dot representing how investors feel at that particular point in time. As we can see on the left side, investors go from optimism to excitement to thrill. All this time, investors are excited about the future of the stock market and the economy, and they are bidding up stock prices to reflect that.

Eventually, things hit a peak. Stock prices rise to a high, and investors feel a sense of euphoria. Interestingly enough, since this is when stock prices are the most expensive, this is when future returns are actually the lowest. It is also the point of maximum financial risk. As Warren Buffett says, "You pay a very high price in the stock market for a cheery consensus." Then as the economy and stock market starts to turn—which it inevitably does—investors’ mood about the future of the economy and the stock market starts to shift.

Investors go from a feeling of denial to anxiety to fear. It then continues on into depression, panic, and capitulation. Capitulation is just a fancy word for saying that investors have given up on the stock market completely. The most negative emotion is despondency. This is where investors have completely sold out of stocks because the future outlook is the most uncertain and worrisome.

This is the point of time when stock prices are the cheapest, and this is actually when it is the best time to buy stocks and represents the ultimate buying opportunity. Things inevitably start to improve; investors' emotions go from skepticism to hope to relief, and then back to optimism as the stock market and the economy starts to recover.

But notice something interesting: the first dot and the last dot are the same; they both say optimism. This is because once things start to improve and investors start to feel optimistic, the whole process starts over and over. This is the way the stock market has worked for centuries.

Look at how similar this actual chart of the stock market from 2003 to 2013 looks compared to Howard Marks's diagram. Yeah, pretty similar.

So that brings us to an important question I want to answer in this video: if we shouldn't rely on economic predictions to make investment decisions, what should we do instead? Based on the countless hours I have studied of Warren Buffett, here are three things I have identified.

The first is to focus on microeconomics rather than macroeconomics. While macroeconomics focuses on the broader economy, microeconomics focuses on the traits in a particular industry. When you focus on microeconomics, you are focusing on answering questions like: Is this company I'm looking to invest in winning or losing market share? Who are the big players in this industry? How much pricing power does this company have? These are all very important questions to the ultimate success of an investment you make, and are a lot easier to know and predict than what's going to happen in the broader economy.

The second is to dollar-cost average into your investments. Now, this is an investing strategy where you invest a certain amount every week or every month regardless of what's happening in the economy. You don't care about whether stocks are cheap or expensive, and you just put a fixed amount every month into the stock market. This is the strategy legendary investor Jack Bogle recommends. He says that an individual should dollar-cost average and completely ignore what's happening in the economy and in the stock market. Instead, just put a fixed amount of money into the stock market every month and wait till you retire to check your account balance.

The third piece of advice is to have a long-term horizon when you invest. Stock prices are highly influenced in the short term by what people think is going to happen in the economy over the next six, 12, or 18 months. However, over the longer term, stock prices are ultimately determined by the underlying fundamentals of the business. Like the old saying goes, cash is king, as the value of any stock is ultimately based on how much cash flow it will be able to produce for its owners.

Also, back to our earlier example of the Howard Marks diagram: when people are worried about what is happening in the economy in the short term, this can provide an amazing buying opportunity for the long-term investor. Remember, the more fearful people are, the better the buying opportunity.

So there you have it. Make sure to like this video and subscribe to the channel if you aren't already, because it's my goal to make you a better investor by studying the world's greatest investors. Talk to you again next time.