The stock market is a fantastic invention of the modern world.
The reason I say this is because both buying and selling is so easy if you have a large, liquid stock market.
If you don’t happen to like a stock that you bought recently on the grounds that its management is not doing a great job, you can sell the stock in the stock market and exit the very next day.
I don’t think there’s any other market that offers this much convenience.
Now, imagine that you are a 10% partner in an unlisted enterprise, and you want to exit because of the same reason i.e. your disappointment with the management.
Is your exit going to be as easy as in the stock market? Well, I don’t think so.
You may have to put in a lot more work to convince the potential buyers of your 10% stake and even then, an exit could be hard to come by.
Worst case, it could lead to you exiting your stake at a significant discount or at a sizeable loss.
No such risk exists in the stock market. If the stock you own is liquid enough and trades in sufficiently large quantities, you can exit at a short notice and may not have to give a significant discount either.
Thus, the liquidity and the democratic nature of the stock market is no less than a boon to mankind in my view.
However, there is every possibility of this privilege getting misused.
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In fact, it gets misused on a regular basis. I am talking about investors using the stock market as a dumping ground for shares of poor-quality companies and robbing the poor, hapless retail investors of their hard-earned money.
Often, companies with weak fundamentals and unproven business models are packaged as the next big thing and are allowed to trade in the stock market.
Lured by the promise of big, fast returns, retail investors end up buying these so called ‘junk’ companies and lose their hard-earned money in the process.
Hence, while the stock market can exist as a great wealth creation tool by allowing you to quickly rectify your mistakes and switch from one stock to another if needed, it can also lead to tremendous wealth destruction as it makes it easy for promoters of dubious companies to offload their shares to unsuspecting buyers.
Well, Warren Buffett has a hack to help you stay out of trouble in the stock market and lead you to fundamentally sound stocks.
He asks a simple question before contemplating any stock purchase. ‘Would I be comfortable holding this stock if the market stays closed for 5 years?’
What a simple yet a profound query, isn’t it?
Often, we give in to greed and end up buying a stock without paying any heed to fundamentals or valuations.
We rely on the fact that someone else will buy the stock at a higher price from us. However, this is a dangerous thing to do as per Buffett.
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Stocks shouldn’t be bought for trading purposes but for the strength of the underlying business and the favourableness of its price vis-a-vis its fair value.
And the query that Warren Buffett has referred to, perfectly captures this sentiment.
If you are okay holding on to a stock even if the market stays shut for 5 years, then you are certainly buying it based on the strength of the underlying business and its cash flows.
You are not looking to make a quick buck by buying today and selling tomorrow or few weeks down the line. And this is how it should always be.
Rest assured that Warren Buffett’s query is at the heart of every BUY recommendation that we make.
However, our preferred duration for the stock market shutdown won’t be 5 years but more like 2-3 years.
You see, the core idea behind buying stocks should be to think of them as investments and not speculative bets.
And therefore, it should not matter if your upside is coming from the gap between price and value closing or from the growth in underlying earnings itself.
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