The truth about markets is that the best investment opportunities are cloaked in fear. Hark back to February and March of 2009. Those were the two most horrifying months of the credit crisis that took root in 2007. Coincidentally, this period also marked the start of an epic global stock market rally that the vast majority of professional investors missed since they resembled rabbits caught in the headlights, convinced that financial Armageddon was at hand. The fear of economic collapse was overwhelming, yet some recognised the situation as being a once-in-a-lifetime opportunity. Many of India’s “Invincibles”—Asian Paints, Crisil, Bajaj Auto, Nestle, M&M and Shree Cements to pick a few—were trading at rock-bottom prices relative to historic valuation norms. Each of them could have been bought with the essential margin of safety that is the hallmark of smart investing. Yet most investors were far too busy selling to notice the anomaly since they were lured by the prophets of doom! By mid-2010, the fog had already begun to lift as central bankers went into overdrive in keeping interest rates abnormally low and easing money supply. As sanity and, perhaps a dash of greed, returned to the markets, prices were headed north. A couple of years later in April 2011 the market scaled new highs.
The gains illustrated in the table on the right point out how fear can create tremendous opportunities for gain. What applies to lemon cola drinks works just as well while investing—darr ke aagey jeet hai! Bad news tends to short circuit the neural network. Selling decisions are catalysed by an emotional reaction to news, further exacerbated by crowd behaviour. When fear defines the perception of stocks rather than a rational analysis of facts, it is usually a clarion call for contrarian behaviour. The mantra for the thinking investor is to buy fear and sell confidence. Massive selling usually indicates that few sellers remain poised to wreak further havoc. In the absence of selling, stocks stop falling. Even a hint of scattered buying can revive stock prices disproportionately going forward. The rebound in the market after the deathly stillness of a major decline has a wonderfully colourful and descriptive name: The dead cat bounce. If survivorship is a key characteristic of success, best to try and have a few extra lives! While this might sound bookish, the truth is that a strong contrarian instinct is the primary intellectual and emotional discipline that defines the most successful investors.
Simply defying the crowd is pointless. Contrarianism is best used to nuance your thinking at turning points to grasp the essence of crowd behaviour. Quite apart from reinforcing the healthy scepticism needed to remain mentally balanced, contrarian thinking ensures that you stick with the odds! As Humphrey B Neill, the father of contrarian investing, put it: “The public is right during the trends, but wrong at both ends!” Charles Mackay, a thinking Scotsman and the ultimate chronicler of crowd behaviour, said it will be seen that men go mad in herds, while they only recover their senses slowly, and one by one. Robert Shiller, a modern day Mackay and Yale economist, has outlined a methodology to diagnose financial bubbles. In his view, the sequence is typically:
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(This story appears in the 12 July, 2013 issue of Forbes India. To visit our Archives, click here.)