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Warren Buffett’s advice on how to handle a 50% drop in the markets

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I’ve been reading through Warren Buffett’s recent letter to the shareholders of his business conglomerate Berkshire Hathaway. He writes one every year when the firm reports its annual results.

But he makes his annual letters available to all, shareholders of Berkshire Hathaway or not. And they’ve become an eagerly awaited feature of the investing landscape for many. You can look for yourself by following this link.

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Timely advice

Normally, Buffett peppers his narrative with memorable and quotable pearls of investing wisdom. And I view the archive as a great resource when it comes to honing my own investing skills.

He signed off the 2019 letter on 22 February, which is close to when the recent pullback in the markets kicked off. How lucky it is (or maybe prescient) that he devotes a chunk of the text to discuss the possibility of a 50% retrace in general stock prices and describes his approach to such setbacks.

Indeed, I find the news flow surrounding the COVID-19 coronavirus outbreak to be worrying. And I reckon it is becoming clear that the virus has the potential to damage the global economy and stymie growth. We could see a world recession. Nobody knows for sure, of course. But there’s no denying that general share prices have the potential to plunge, even from where they are today.

Anything can happen

However, Buffett is well known for his refusal to make macro-economic predictions and he explains his reasoning for that in the letter. Forecasting interest rates, for example, “has never been our game,” he said. And he has “no idea” what rates will be over any timescale.

But he does think that if anything near the current low rates should prevail over the coming decades. And if corporate tax rates remain near the current low levels, it is “almost certain” that equities (shares) will outperform long-term, fixed-rate debt instruments.

That’s a restatement of something he’s been saying for years – shares will likely always do better than assets such as bonds. But here’s the timely advice  in the letter: Buffet reckons “that rosy prediction comes with a warning.” Namely, that anything can happen to stock prices tomorrow. And we now know that COVID-19 happened to them before his ink had time to dry!

Buffett explains in the letter that, occasionally, there will be major drops in the market, “perhaps of 50% magnitude or even greater.” Yet he thinks what he calls “The American Tailwind” will combine with the wonders of compounding. This will make equities “the much better long-term choice for the individual who does not use borrowed money and who can control his or her emotions.”

Indeed, the USA has enjoyed a remarkable century or so of prosperity, and going forward, I’m bullish about the prospects for the UK as well. Buffett’s message is clear – no matter what the wider market does, keep investing and keep compounding your gains in the stock market. By the time you retire, you’ll probably be glad you did!

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Kevin Godbold has no position in any share mentioned. The Motley Fool UK owns shares of and has recommended Berkshire Hathaway (B shares) and recommends the following options: long January 2021 $200 calls on Berkshire Hathaway (B shares), short January 2021 $200 puts on Berkshire Hathaway (B shares), and short March 2020 $225 calls on Berkshire Hathaway (B shares). Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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