Fear and Greed in Investing
You can gain only if you keep these emotions at bay and adopt a contrarian approach to investing
In an ideal world, investors would always make money. They would buy low and sell high. It's a simple and logical statement, yet many investors find it hard to implement. Let us take a look at what motivates and drives investor behaviour, and what we can learn from it.
Rewind to 2001. The Al-Qaeda attacked the twin towers of the World Trade Centre in New York. As terrified office goers made their way down the smoke-filled stairs to safety, they encountered a group of men in gas masks and fire uniforms climbing into the engulfing smoke and fire. They went up 93 floors to rescue people, knowing well that they wouldn't possibly survive the day. Of the 2,753 dead at the World Trade Centre, 343 were fire fighters. What makes fire fighters do this for a living? What makes them confront their worst fears and yet have the conviction to persevere? Another example of extreme conviction is from the 1990s, the height of the dotcom boom. Technology start-ups mushroomed at an incredible rate, and though many of them had no revenues or cash flows, they enjoyed billion dollar valuations. Future earnings were extrapolated on the basis of the number of views a site received. The investors who speculated in these companies grew rich overnight. In the midst of this frenzy, Warren Buffett declared he would not invest in businesses he did not understand. He was panned by other investors as outdated, but we know how that story ended.
Both these are examples of people who challenged the norm. In the first instance, where fear prevailed, a few held their resolve and went against their natural instinct of self preservation. In the second instance, while everyone was euphoric about the meteoric rise of technology stocks, at least one person was not swayed by this irrational exuberance and chose to stay away.
Fear and greed--both are extremely powerful emotions that drive the markets. Anyone who has been an investor over the past 10 years has been there. Greed drives us to buy more when the markets are helium-filled balloons, and fear pushes us to sell when the markets are like a limbo dance--how low can you go?
The market's price to earnings (PE) ratio is a quick way to understand if the market is cheap or expensive. When you are looking at a single company, its PE ratio compares its share price with its earnings per share. The PE of the Sensex is nothing but the same ratio of the 30 largest companies. A high PE means that investors are willing to pay a premium price for stocks. Investing at low PEs is akin to buying at a discount. The long-term average PE of the Sensex is around 15. During 2007-8, when the average forward PE was 20.5, investors poured over `52,000 crore in equity mutual funds. Contrast this with 201112, when the average forward PE was 14.8, and only `504 crore found its way into these funds. Clearly, the grip of greed and fear is very powerful.
Let us see how these investments fared. An investment of `1 lakh in December 2007, when the PE was 26, became `85,000 five years later, a loss of 15%. On the other hand, `1 lakh invested in November 2008, when the PE was only 11, became `2.28 lakh five years later, a profit of 128%.
People clearly bought when they should have sold, and sold when they should have bought. This constant mistiming of the market and resultant losses are the main reasons many Indians keep away from equity, viewing it as gambling rather than a reliable long term wealth creation engine. As a result, a dismal 3% of our population holds faith in the equity markets.
Yet, in the long run, stocks create more wealth than any other asset class. Not just in the past year, when we have seen the pendulum swing gradually from fear to greed, but over the past 35 years of the Sensex's existence. At around 27,000 now, it was at 100 in March 1979. This translates into money doubling, on an average, every four years. Add the dividends, and the story seems even better.
So how do we keep our emotions in check?
It is not important whether the market has underperformed for three, four or five years. The right time to invest in equity is when the PE is low. Good returns are seldom made on investments in good times. As long as you have invested when the market PE is low, you will stand to gain when the markets and PE multiples eventually pull up.
My point is, you can make money in the markets if you are an intelligent investor. An intelligent investor makes intelligent decisions. Intelligent decisions are made when you can sense the herd mentality and beat it. This is hard and you must be prepared to `walk alone'. If you are contrarian, people may perceive you as being a little crazy, but that's ok. Robin Williams once famously said, "You're only given a little spark of madness. You mustn't lose it." The good thing is, it might even make you some money.
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