This Is Warren Buffett's No. 1 Tip for Protecting Your Investments Against a Bear Market

When investors think about risk, it's usually in terms of how much their portfolio's value has dropped.

Warren Buffett sees it a little differently. He differentiates between short-term price losses in a stock and the fundamental loss of value in a company. The former is a normal part of the investing process. The latter is something you want to keep out of your portfolio.

In his 2024 annual letter to Berkshire Hathaway (NYSE: BRKA)(NYSE: BRKB) shareholders, Buffett alluded to this when he said:

"Never risk permanent loss of capital."

It's one of the most useful lessons investors can learn before the next bear market.

Warren Buffett. Image source: Getty Images.

Warren Buffett doesn't try to avoid falling stock prices

Most people already know that Warren Buffett doesn't try to time the market. His investing style is to identify strong, high-quality businesses trading at attractive valuations. He then buys those companies and hangs on to them for years, if not decades.

Now imagine a scenario in which a bear market causes the S&P 500 (SNPINDEX: ^GSPC) to fall by 30%. Your brokerage statement says you've lost money. But the Buffett framework of thinking works differently.

Just because the value of something declined by 30% doesn't necessarily mean that the market or the company has suddenly become 30% "worse." If the bear market stems from a downturn in overall economic activity that causes everything to fall in value, the underlying quality may not change. In that case, Buffett may view it as a prime buying opportunity.

But permanent losses come from a different place. If a company runs into financial trouble because it's taken on too much debt, loses a competitive advantage, or is struggling to grow its business at all, that's the kind of situation that can destroy value permanently.

Buffett's philosophy has always involved owning companies he understands that have good long-term economics, an attractive valuation, and the ability to generate earnings growth over time. These types of companies are unlikely to experience a permanent loss of value. A market downturn could trim 20% off their stock price. But they're in an economic position to regain it once the market recovers.

In other words, market volatility isn't necessarily your enemy. Owning the wrong investments is.

Prepare for the bear market before it happens

Berkshire Hathaway has maintained a huge cash position on its balance sheet for years. Buffett has said in the past that he couldn't find any attractively valued opportunities, so he's had a big chunk of his portfolio sitting in cash on the sidelines. The idea is to have it ready to put to work when that opportunity finally appears.

Retail investors should follow the advice on a smaller scale. Having some cash on the sidelines in your own portfolio can help you take advantage of pullbacks or value opportunities.

But make sure you have an emergency fund in place first. You don't want to be selling equity positions in your portfolio against your will because the bear market was caused by a recession and resulted in a job loss. Keep that emergency money separate to cover unexpected cash needs. Then you can focus on using actual portfolio cash to take advantage of market corrections as they happen.

Here's how I'd apply the Buffett rule

There's nothing wrong with having a small percentage of your portfolio invested in something more speculative with higher return potential. But you don't want it to become a large piece of your portfolio.

The core of a portfolio should be built around high-quality companies with healthy balance sheets that can survive bear markets and recessions. These are the stocks that are unlikely to disappear but can provide good buying opportunities during downturns.

Build the long-term portion of your portfolio around these stocks and the ETFs that hold them, such as the iShares MSCI USA Quality Factor ETF (NYSEMKT: QUAL). And try to feel comfortable enough holding them through tough markets and economies.

Buffett's lesson is that you shouldn't try to predict when stocks will fall. But to be prepared to take advantage of it when they do.

David Dierking has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Berkshire Hathaway. The Motley Fool has a disclosure policy.