Why Warren Buffett Was Wrong

Since posting the article on my blog about the bottom of the stock market a couple of days ago I have received numerous emails on the subject so I thought I would expand on it a bit and give some further thoughts.

The one big question I have and would like to put out to everybody for them to think about is why is it so important to buy the bottom of the market anyway? I believe that the reason people are looking for the bottom is ego based and not profit based. People want to be right and say “look how smart I am, I bought the bottom of the stock market”.

Instead of trying to be “right” traders should be concentrating solely on making money. The fact remains that the best traders are those with a relatively low win percentage i.e. they are wrong more often than they are right, but when they are right that make more money than they lose when they are wrong and the difference is their profit.

As I have written before, the markets trend around 40% of the time and that is about the same as the percentage of winning trades that a good trader or trading system will produce. This is roughly the percentage of winning trades that the LS Trader system produces but over time the system is well ahead of the game.

Currently the trend in the stock markets is down. The long term trend and the short term trend is down so there is no reason as far as I can see for people to be trying to fight these trends and buy this market right now.

I believe that the trend in stocks is going to be down for a while yet and I don’t see the LS Trader system giving a buy signal on stocks for the rest of 2009. That does not mean that there won’t be rallies because there will most certainly be rallies and up weeks, possibly even up months, but after all is said and done the long term trend will remain down for the foreseeable future.

In the meantime there will be countless traders trying to predict the bottom and try to buy the bottom of the market and even look for market bounces and try to buy them. My point is, rather than fight the trend and guess why not just follow the trend and go short?

Using trend following, traders don’t need to guess or predict where the bottom of the market is but simply follow the trend. When the trend reverses the trend follower simply exits the trade and waits for the next trend to develop. Trend following is reactive, not predictive.

The fact remains that huge sums of money is and has already been lost by people in search of the bottom of the market. Just ask legendary investor Warren Buffett. Buffett attempted to call the bottom of the market months ago and was wrong in a big way, so far losing billions of dollars.

What is Buffett’s reason for buying the stock market? It seems that he has 2 main reasons:

  1. He likes a bargain. He said a day or 2 ago that he likes to buy quality merchandise and knock down prices. Problem with this is that what may appear cheap today could very well be expensive tomorrow. As I have said before, there is no such thing as value in the markets as the markets are always right. Therefore, the current price on offer for any market is the right price at that particular moment in time.
  2. He believes that you should be greedy when others are fearful and fearful when others are greedy. This is a popular theory and seems logical. The fact is that it is just not accurate enough as an indicator and Buffett’s experience in this example is proof positive of that.

The problem with both of these approaches is that they are both counter trend. Counter trend approaches when tested over market history show a negative expectancy as they are not statistically valid.

The question is then why does Buffett do this? Well, firstly there is an important distinction that Buffett is a long term investor, not a trader and he will therefore be taking a longer term view. He obviously also believed that when he was buying the market that we were either at or near the bottom. He was wrong.

In my opinion he is making a mistake because he has probably at best parked his money for a couple of years before it climbs above the levels that he bought at. Secondly, he is clearly very well capitalized and can afford to leave his money parked for a couple of years or so and even lose some money in the meantime until the markets recover. Other less well funded traders or investors cannot adopt the same approach.

As I have written in the previous article, the future cannot be predicted as it does not yet exist and there are way too many unknown variables, not least of which being crowd psychology and the emotions of greed and fear and therefore nobody knows either where the bottom of the market is or how long the recovery will take. If I had to give an opinion I would say that the stock markets will not make new highs for at least 5 years.

Yours for bigger winners, more often

Phil Seaton


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