Why it is so difficult to sell on greed and buy on fear…

The simplest piece of advice that any seasoned investor will give you is to sell on greed and buy on fear. Intuitively it is a very simple logic. When there is greed in the market, investors are willing to pay sky-high valuations for stocks. Such circumstances are ideal for selling out and not for buying in. That is when your ability to resist the herd instinct and sell when others are buying can go in your favour. Similarly, in times like 2002 and 2009 when stocks were priced at ridiculously low valuations, was the time to buy. On such occasions, if you can stand against the herd and buy when everyone is selling, it can result in huge profits.

The above logic is simple and alluring. Yet, very few people manage to sell on greed and buy on fear. The point to understand is why is selling on greed and buying on fear so difficult in reality. There are actually 3 reasons for the same…

It is all about peer pressure…

Most of the investors tend to buy what is sold to them and not what they should be buying. It is during market peaks that you will find a plethora of IPOs in the market; you will find analysts recommending stocks at steep valuations; you will find traders telling that the market structure is changing etc. These forces are extremely hard to resist. More so when you see you neighbour has just bought a banking stock at 35 times P/E and sold it off at 40 times P/E. This is what we call the peer pressure. The irony is that if you try to sell on greed, you need to go through a series of disappointments and see your friends making money in the midst of a raging bull market, while you do not. The same applies in case of fear. You keep buying at attractive valuations and the stock continues to dip. It is this peer pressure that makes it so difficult in reality to buy on fear and sell on greed.

You typically fall for the argument, “this time it is different”…

We have heard these arguments so often in the past. At the peak of the technology boom in 1999, most technology analysts said that 100 times P/E for Wipro was justified because at the end of the day technology was about to bring about structural changes in the world economy. Similarly, in 2007 we heard arguments about how real estate companies need to be valued at a multiple of their land bank values and not their earnings. Eventually both these arguments flopped. Technology did not structurally change the way we did business and most technology stocks lost nearly 90% over the next few years. Similarly, land banks turned out to be notional figures when the entire valuation of land parcels started to crumble. Not surprisingly, most realty companies lost nearly 95% of their market value and are nowhere close to their peaks even after 8 years. As John Templeton rightly said, the most dangerous argument in capital markets is “This time it is Different”.

At a ground level, it boils down to liquidity…

Your ability to be greedy at the bottom is largely a function of your ability to have been fearful at the top. In the absence of that you end up with stocks that have depreciated substantially from their peak levels and hence your money is stuck. You do not; therefore have the required liquidity needed to buy stocks when the opportunity arises. Therefore, unless you are fearful at the top, it is very difficult to be greedy at the bottom. You liquidity situation does not permit that.

There is another angle to the liquidity argument. Market peaks generally tend to lead economic peaks. By the time the market has turned down, the liquidity in the economy is tight and required funds are not easily available. Even if you have the conviction, the financier does not have the conviction at those levels to finance you. That is the crux of the problem.

So that is why buying on fear and selling on greed is so difficult in practice. Great investors like Warren Buffet have practiced that to perfection. But it calls for an ability to keep a discipline and keep your stomach from churning. The big challenge as we said above is the ability to be liquid when opportunities arise. That is where most investors fail. Their propensity to hold on to losing positions for too long results in MTM losses which makes buying on fear almost impossible!

One way investors can address this issue is to keep a valuation discipline in their portfolios. For example, say you have bought an IT stock at 18 times valuations. If the historic average valuation is 23 times earnings and the stock goes 10% above that, then you exit. That means at 25 times earnings you exit. That may imply that you miss out on the last frenzy of the stock, but that is a risk worth taking and a profit worth forsaking. At least, by liquidating your position close to the peak, you are well funded when the moment of fear arises. That can be a starting point for you.

You can ask us your stock related questions with #AskReligareOnMarkets via our Twitter channel @religareonline

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