Be Afraid, Be Very Afraid… Don’t

Markets are crashing! TV talking heads are somber and speak as though they are covering a funeral of war victims. The newspapers report that Facebook shares fell 4% in one day, heralding the end of social media. Prominent firms tell their clients to get all their assets out of stocks as they are crashing. Many individuals you know send in redemption requests to their Mutual Funds and ask you why you aren’t doing the same. Better to take a small loss than lose everything. Everyone knows stock markets are a scam.

Even if this isn’t happening right now, chances are that sometime this year; these events may come to pass. Are you prepared for it?

Knowledge is the best preparation. Emotions are the worst impediments to rational decision-making. As an investor myself, here are a few tips to guide your investment decision-making:

  • Market crashes are a well-documented part of known history. In his book Manias, Panics and Crashes, Charles Kindleberger documents market cycles from 1618 to present. There have been at least 40 such prominent episodes. The world has survived. Humanity didn’t end. Businesses didn’t all close their shutters. Even accounting for such episodes, stocks are still a great long term investment, beating fixed income instruments hands down.
  • Valuations eventually do matter. A commonly used valuation metric is the PE ratio. A PE ratio of 10 implies that investors are paying in advance for 10 years of current year earnings. If the earnings stay stagnant, you recover your initial capital in 10 years and reap a profit from the 11th year onward. Sounds reasonable. What happens when you buy a stock with a PE ratio of 900? Earnings need to go up 90 times before it reaches a PE of 10. On average, no company is a good investment for 30-40 years because changes in the corporate landscape change the prospects of whole industries. Railroads were hot in the late 1800s. In the 1930s Great Depression, most of them were bankrupt or suffered terrible falls. The chemical industry was hot post-WW II. Now, the mainstream pays no attention to them. There are dozens of such examples. Going back to our 900 PE stock, let’s assume that the company manages to grow its earnings 90 times within a decade – a very generous assumption. Ten years to recover initial capital, followed by 10-20 years of profiting from the company’s earnings – assuming the company is alive and maintaining its earnings for that long. The long-term track record of that isn’t so good. Our “investor” holding a 900 PE stock is not investing – he is merely gambling, waiting for a greater fool to come along and buy it at a higher multiple. If you have invested in reasonably valued stocks, staying invested without attempting to time the market cycles will generate greater long-term returns. The research on this comes from Jeremy Siegel’s Stocks for the Long Run.
  • In a bull market, no one likes cash. It can always be put to work earnings easy returns in the markets. In bear markets, no one likes stocks. It feels ‘safe’ to just hold cash and lose a small percentage steadily to inflation. In bear markets, stocks become undervalued due to the emotional nature of most investors. That’s the perfect time to pick up bargains. As Baron Rothschild famously said, the time to buy is when there is blood on the streets. You can either have comfort (cash) or great prices (bargain-priced stocks). Pick one. Treat a stock market sale the same as an end-of-season sale or Black Friday sale at the mall. Buy!
  • Do your research beforehand. I’ll buy ABC because I know the company and like its prospects, if it falls to Rs. X. Doesn’t matter if it further falls to Rs. 0.8 X due to the doom and gloom around you. As long as you pay attention to valuation and really understand the company, a lower price is simply an opportunity to buy more. Take it.
  • Depending on your assessment of the probability of a crash, raise cash beforehand, so that you will have cash to deploy and buy aggressively when others are selling. When the cycle turns, you’ll get your rewards. You can either look like a fool during the crash for aggressively buying or after it for having missed your chance.
  • Write down your investment rationale. Sell when reality contradicts your well-thought out investment thesis, not because the price fluctuates. If you invested in a company because the earnings generated from a new product line aren’t properly appreciated by the market, be prepared to sell when that product line sinks beyond hope of redemption, regardless of whether you’re sitting on a profit or a loss. Only devote capital to your best ideas, and be prepared to walk away when your ideas are proven wrong.
  • Cut out the chatter. Looking at the markets all day long when you’re going against the grain is a form of positive punishment (HT: The Big Bang Theory). You don’t need to emotionally sucker punch yourself every day for doing the right thing and sap your self-confidence. Read, research, invest and pay attention to valuation, not chatter. It’ll help to think of mediapersons as the “chattering classes”.
  • Just as an MBA accelerates managerial growth, bear markets accelerate your returns compounding. Make up for any lack of prior saving by seizing this opportunity.

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