Remember when everyone was quoting Baron Rothschild, saying, "Buy when blood is in the streets"? Well, this is it. We're in the Wall Street equivalent of Kill Bill meets Jurassic Park. It looks like it's all over but the spurting.
Warren Buffett knows how to play this game. He's buying, and he says that in five or 10 years, "We'll look back on this period and we'll see that you could have made some extraordinary buys."
But when the market drops 9% in a day, it's hard to react logically, like Buffett -- and not, say, curl up into a quivering, sniffling ball. Here are five ways to help you achieve your goal.
1. Be afraid -- be very afraid
Instead of looking at how much you can make by buying a stock, examine all the ways that you can lose. Bruce Berkowitz, who manages the Fairholme Fund, swears by this strategy. He tries to think of every possible scenario that can kill a company -- and if he can't find any, then he'll buy. As of the fund's most recent semiannual report, he owned major stakes in pharmaceutical makers such as Pfizer (NYSE: PFE ) and diversified holding companies such as Berkshire Hathaway (NYSE: BRK-A ) .
Even ridiculously paranoid scenarios deserve consideration. A year ago, it was inconceivable that a handful of the nation's biggest banks would go out of business and that credit markets would essentially freeze. But just because it was inconceivable, that doesn't mean it couldn't happen -- and it did.
In this environment, where no one is lending, you should be especially paranoid about debt covenants and maturing debt. Even if a company is profitable, a large debt maturity that it can't roll over could drive it into bankruptcy. With economic conditions as they are, companies are making moves they wouldn't have considered if the market were better, like AAA-rated General Electric (NYSE: GE ) and its decision to sell preferred shares to Warren Buffet that pay 10% interest.
2. Avoid black boxes
Be suspicious of companies you don't understand or whose financials are opaque. In fact, unless you understand the business model, don't buy it at all.
Sure, Goldman Sachs and Morgan Stanley (NYSE: MS ) may have survived the purging that took down every other investment bank in this country. But unless you fully understand their portfolios -- which seems almost impossible right now -- it's difficult to be confident that their businesses are rock-solid.
The same sort of reasoning applies to retail banks with labyrinthine liabilities, such as National City (NYSE: NCC ) and Colonial BancGroup, as well as to bond insurers like MBIA. If you can't assess the risk, you can't be confident in the investment -- especially when blood is flowing like water.
3. Invest only money that you don't need soon
Assume that the near-term market will remain volatile -- even after it smooths out. That approach will prevent you from investing money you need in the near term and thus protect you from losses you can't sustain.
Think of it this way: Suppose that you do find one of Buffett's extraordinary buys and are brave enough to pick it up. Then you're set, right? Well, not entirely. You can still lose if you're forced to sell. Remember, Buffett isn't saying these stocks will become 10-baggers tomorrow, or even next year. He's talking about five or 10 years.
So when you buy, don't buy with money you'll need soon, and definitely don't use margin. If you're forced to sell at a bad time because of a margin call, then you could lose money even if you've successfully identified a stock that goes on to become a 10-bagger.
For instance, immediately after the 9/11 tragedy, you could have bought Coach (NYSE: COH ) at a cheap $27.50 per share. But a few days later, it traded down to $21. If a margin call forced you to sell at that price, then you would have missed seeing the stock become a 10-bagger over the subsequent five years. Ouch.
4. Ease in
And all of that means you should be suspicious of how your chosen investments will perform initially. When the market's this volatile, don't put all of your money into a stock all at once. Instead, put a portion in when you see an attractive opportunity, but save some cash to buy more if it falls.
Some people buy in thirds on the way down so that they have two chances to average down without becoming overexposed to the stock. I recommend buying enough that you'll be happy when your stock goes up, but little enough that you'll also be happy if it falls significantly and you can buy more. I originally purchased Legg Mason in the mid-$60s. The descent hasn't been fun, but it's easier to handle knowing that I can buy shares at an even lower price now. And I have.
5. Buy at a discount
Of course, the whole reason you're trying to buy when there's blood in the streets is that that's when stocks are trading at big discounts to their fair value. Those discounts can propel your portfolio to extraordinary returns -- the bigger the discount, the bigger the potential return. Plus, a good understanding of a stock's intrinsic value can give you the confidence to hold in today's volatile market.
But make sure you're buying shares that are actually cheap. Many companies are trading at prices far lower than they were a year ago -- but that doesn't mean they're cheap. Yahoo! (Nasdaq: YHOO ) had fallen a lot by early July, but it was still expensive.
The Foolish bottom line
There's blood in the streets, so if you can handle the volatility, it really is a great time to invest -- but invest suspiciously and fearfully. It will do your portfolio good if you do.
Our Motley Fool Inside Value team has turned its skepticism on this bear market and found many companies we consider exceptionally attractive right now. That doesn't mean they'll skyrocket tomorrow, but we do think they'll prove to be extraordinary buys at today's prices. You can read all about our top picks, including our best bets for new money now, with a free trial. Just click here to get started -- there's no obligation to subscribe.
This article was first published on October 3, 2008. It has been updated.
Fool contributor Richard Gibbons was praying that the killed Bill wouldn't be the bailout one. He owns shares of Legg Mason but has no position in any of the other stocks discussed in this article. Coach and Berkshire Hathaway are Motley Fool Stock Advisor recommendations. Legg Mason, Berkshire, and Pfizer are Inside Value picks and Motley Fool holdings. Pfizer is also an Income Investor selection. Fairholme is a Champion Funds recommendation. The Fool's disclosure policy eats velociraptors for breakfast.