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Value Investing : The Pendulum of Greed and Fear
Since the time I learned about value investing, I have been an avid follower of Warren Buffet.
One of Warren’s most famous quotes is “Be Fearful When Others Are Greedy and Greedy When Others Are Fearful.”
To fully understand, What Warren meant by this statement in the context of investing, and how we can benefit from it?
We need to take deep dive into value investing principles, investor psychology and the cycle of boom-bust.deep dive into value investing principles, investor psychology and the cycle of boom-bust.
Over the years the above quote has made me think more and more about the pendulum-like back and forth movement in investor behavior caused by emotions of greed and fear.
In this article, I have decided to break down my thinking, so that you understand this value investing principle and become a better investor.
Market Sentiment and Investor Psychology
After 11 years of investing in the stock market here are few of my observations which will help you tremendously:
Two factors drive the level of Stock prices in the short-term:
- Market sentiment
- Investor psychology.
Because the market consists of participants who have human emotions, market sentiment at any point in time is driven by greed and fear.
Fear and greed are two most primary emotions which motivate you to take action or inaction.
As human beings, it is our inherent nature to move away from pain and towards pleasure.
This pain-pleasure principle manifests itself in the form of greed and fear in the stock markets.
The market sentiments and short-term prices move from one extreme to other like a pendulum:
- Extreme Optimism and Pessimism
- Celebrating positive news and being overly critical on negative news.
- Stock prices are moving back and forth from overvalued to undervalued.
Furthermore, the stock market moves in cycles of Boom and Bust. Every few years the economy is in an upswing, and things are going well, this over-optimism or greed causes investors to buy without paying attention to risk.
The boom period is often followed by a bust and markets go into a panic mode.
During this period the stock prices are at the bargain, investors lose all willingness to buy and rush to sell.
Even though one may believe that most of the time the market sentiment is at an equilibrium or midpoint between fear and greed reflecting the real value of the stock market, this is far from the truth.
The reason for extremes is that as part of our mass psychological makeup we as human beings feel safe in numbers.
Whenever this pendulum of greed-fear moves towards one extreme, it is inevitable that it will back towards the equilibrium or midway point sooner or later. Just like in the case of a pendulum, markets the even markets the movement towards one extreme supplies the energy to move back.
Another important factor apart from greed and fear which adds to the pendulum swing of the markets between overvalued and undervalued is the attitude of investors towards risk tolerance and risk aversion.
Risk Aversion is the most important element of the stock market sentiment. As part of our psychological make-up, we as human beings avoid losses. This tendency to shy away from risk or avoid losses is risk aversion.
In a bull market, investor tends to find investment less risky or are less risk averse. At its peak or what can be categorized as a bubble, investors are less risk averse or overly optimistic and willing to pay high prices for stocks. When there is a bubble, greed clouds judgment of most investors making them feel that there is no risk and stock prices will keep going up forever.
On the other hand, in the case of crashes and at the peak of bear markets there is a lot of fear in investors. Investors become excessively risk averse which clouds their ability to see the value and buy stocks at low prices.
Therefore, I would argue that greed and fear are barriers within us which hinder us from making good investing decisions, i.e., buying when stocks are undervalued and selling when stocks are overvalued.
When greed drives the stock market sentiment, it means that investors feel comfortable with taking on more risk in their pursuit of profit.
Similarly, when fear drives market sentiment, it means investors are fearful to take on risk.
Most experts and academics believe in the theory that High risk equals high returns.
However, think about this if high risk = high returns then everyone should take more risk and get good returns. What people forget is that risk means loss of capital or investment.
Therefore the statement that high risk equals high return is contradictory
However, there are times during the peak of a bull market or bubble when investors forget about risk and buy stocks at high prices which do not justify the risk. An example of this would be paying very high P/E multiples with the assumption that a company will continue to grow its profits forever. On the other extreme, when investors are scared during crashed they demand an extremely high return for taking the smallest amount of risk. They feel growth will never return and focus too much on the negative aspects of a company; this is when they miss out on the best deals.
Understanding of the pendulum of greed and fear is the best tool a value investor can have at his disposal.
The two types of Fear.
As an investor you will experience two types of fear:
- Fear of losing money
- Fear of missing out on an opportunity.
In a perfect world or market, investors would have the ability to balance perfectly between the two. However human beings are far from perfect. This flaw in us causes the pendulum to move from one extreme to another. At each of end of the pendulum (market swing), one of the above fear dominates the other.
Allow me to give you an example:
- In 2006, 2006 and 2007, there was a stock market boom. With share prices on the move up and good news all around, very few people could imagine that there will be a crash in the subsequent year. Most investors felt that there was no risk at all in stocks. The only fear they had was that they would miss out on the opportunity if they did not buy shares regardless of the price and other investors would make money. They were willing to pay high prices for stocks without thinking about the risk or how risky the investment was at that price. Investors were extremely aggressive at this point.
- In the coming years of 2008 and 2009. With the crash of the sub-prime crisis, investors began to fear the failure of the entire financial system. The fear of missing out on the opportunity changed into the fear of losing money. Investors become overly risk averse running away from stocks and selling them at any price. Thus missing out on opportunities to buy stocks cheap by behaving too defensive.
Keeping the pendulum of greed and fear in mind, this an excellent example of how amateur investors do the wrong thing at the wrong time.
When stock prices are moving higher, and things are good people rush to buy, forgetting about the risk of losing money. After the bubble bursts and stock price are low, investors get scared about losing money and rush to sell. This is a very good example of the pendulum of fear and greed at play.
To sum up here are the key observations from our discussion:
- The stock market sentiment is driven by greed and fear like a pendulum.
- It moves from one extreme to another rather than be at the midpoint because of inherent human nature and investor psychology.
- The pendulum cannot continue to keep swinging or stay at one extreme forever. A bull market ends with a crash, and a recession is followed by a bull market sooner or later.
- As is the case in that of a pendulum, swing in investor sentiment towards one extreme of either greed or fear adds more and more energy to the pendulum to swing back towards the other extreme.
- Market crashes and upwards movements from extremes towards the midpoint are faster than the time it takes to move towards an extreme.
We can be confident of the pendulum of greed and fear to go from one extreme to another in the stock market from time to time.
Remember these Key Points!
However, there is some uncertainty on the following questions.
- How long will the pendulum continue to swing in one direction? Or how long a bull or bear market will last?
- What event or news will cause the swing to stop?
- When will market sentiment or pendulum of greed and fear reverse?
- After the reversal happens how far will it swing in the opposite direction?
There are very few things we can be sure of in the stock market. The pendulum of greed and fear is one of them. Extreme behavior either bullish or bearish will eventually reverse. Those investors who believe that the pendulum of greed and fear will move in one direction forever will lose a lot of money. Those who understand the pendulum’s nature to take advantage of other mistakes will enjoy attractive returns.