You Only Find Out Who is Swimming Naked When The Tide Goes Out

What did Warren Buffett mean when he said, “You only find out who is swimming naked when the tide goes out?”

Clearly, he is talking about two things:  Quality of Stock, and Price Paid for Them.

When the share market is in the midst of a “Bull Run”, the market value of your portfolio will certainly cover-up all mistakes made in selecting the company and the price paid for acquiring the shares; every stock in the portfolio shows a blue tick, and a unrealized gain, prompting the lay investor to falsely believe he is a great investor, bestowed with abundant investment wisdom.

No wonder, the seasoned value investor’s portfolio too, is showing significant growth – may be on par with the benchmark index, like BSE Sensex, or surpassing it or underperforming it – nevertheless it’s value has certainly grown.  However, the “value investor”, trained unceasingly in keeping the emotions under strict control, is Stoic. 

In fact, you can observe a distinct deviation in her behavior, either she is very parsimonious in investing in stocks or has given the market a total miss; instead, preferring bonds or other fixed income securities.  On rare occasions you may observe that the value investor had sold shares of a company or two, at handsome profits of course, which had recently gone through some fundamental changes, which are not to the liking of the investor or which are contrary to value investing principles.

On the other hand, our lay and ignorant investor, who is under the false credence of superior investment acumen, is continuing to pour money into the stock portfolio.  Drunk with “Greed” and “Overconfidence”, he might be investing even borrowed money.

The markets are on a roll, in the meantime, lulling the investor community, the so-called “Experts”, media, regulators and political leaders into a false sense of everything-is-going-good feeling.

At last, the time for reckoning arrives!  Some catastrophic Global Event like Lehman Brothers triggers a market crash.  Portfolios world over start bleeding.  Margin Calls and unilateral squaring up of traders’ positions accentuate both the market fall as well as lay investor pain.  Euphoria, which was prevalent, not so long ago is replaced with gloom. 

The tide is going out fast, and you find out who is swimming naked -  who is safe and who getting washed away in the tide.

Risk Comes from Not Knowing What You are Doing

Businessman jumping across the mountain taking risk

Driving an automobile is Not Risky; driving, without adequate training is – not only to the driver but also to all other unsuspecting road users, and that is why my Guru, Warren Buffett said, “Risk Comes from Not Knowing What You are Doing”.

Often I have heard people proclaim, sporting an, “I Know Everything” smile, that they diligently avoid investing in stocks, as it is Highly Risky.  On questioning how they had come to such a conclusion, they would invariably attribute the wisdom to their parents, teacher, colleague or friend. When questioned where they would prefer to invest, they would retort, with authority, “Corporate Fixed Deposits and Bonds – Rock Solid Safety”.  Sadly, after a few years, I have seen many of them Loose both Capital and Interest, and repent their poor investment decisions.

The moral of the story is, Risk or the Lack of It, does not lie in any particular instrument, but lack of knowledge.  A fixed deposit with a government bank in India indeed is as solid as rock, there is no doubt, but with an interest rate around 7% per annum and inflation near or above the rate of return, the “Value” of your investment is bound to be eroded for sure, over a period of 15 to 20 years.

On the other hand, if an investor had invested Rs.1,00,000 ($ 1470) in “NIFTY 50” in January 1995 and had simply forgotten about it, today in June 2016, it would have grown to Rs.809,400, a growth of 709% or a Compounded Annual Growth Rate (CAGR) of a whopping 32.99% per annum.  Even after an assumed, high, inflation rate of 10%, the investor would be left with a net return of 22.99%, Compounded Every Year!  So, Where Does Risk Lie? Not in the “Instrument”, certainly, but in “Ignorance”. 

Who is Afraid of Brexit, Really?

Last Friday, the 24^th June 2016, which the media christened “The Black Friday”, when the global financial markets roiled, and lost over $2 trillion in value, Foreign Institutional Investors (FIIs) sold shares valued Rs.629 crore ($92 million), and retail investors purchased stocks worth Rs.118 crore ($17.50 million), which raises the important question, who really is and should be Afraid of Brexit?

It is not suggested here that global fears regarding Brexit are a Hoax, but merely that the jitters are exaggerated, and purely temporary.  We must realize that all the 28 member nations of the European Union were independent, sovereign states in the first place, before they voluntarily came together to form the common market.  So the sky is not really falling nor is it going to in future.

What remains to be understood is who is scared, who is not; who should be and who need not.

FIIs who pumped dollar funds into the Indian stock markets over the years, and jacked up the valuations to unreasonable levels, panicked and sold.  They also sold fearing irrational redemption by their investors back home. 

Value investors and even lay investors who invest in mutual funds and Systematic Investment Plans (SIPs) need not be and should not be Afraid of Brexit, and simply sit tight through the present turmoil, Nay aggressively purchase and accumulate shares of those excellent companies, which were pricy and unaffordable earlier.  In fact, right now, it is the Golden Opportunity to Master one’s temperament, and to Exorcise the Emotional Ghost called “Fear”.

Value Investor Buys From A Pessimist And Sells To An Optimist

Widespread but totally irrational is the behavior of many a lay investor on the stock market.  They buy high and sell low, totally opposite to what commonsense demands.

Greed and Fear, the twin internal ghosts that had remained unexercised, is at the root of this sad malady.  Anyway it is a long and different story; let us focus on the subject at hand.

Lay investors usually enter the stock market very late, nearly by the end of an enthusiastic price surge – a Bull Run. They know very little about investing, leave alone investing in shares.  They enter out of greed, lured by chances of making a fast buck. Mostly they borrow money – at high interest – and invest.  The prices they pay for the shares they buy are invariably high and unsustainable.

While the lay investor can be excused for their judgmental error, the mutual fund managers, who are supposed to be experts, and on whom millions of ordinary investors repose their trust also end up in the same situation, not out of ignorance, but due to circumstances.  During enthusiastic market conditions, a large and different kind of lay investors, again drawn by the desire to make fast returns and aware of their ignorance of financial markets, pump money into mutual funds, a relatively safe and prudent bet under the circumstances, in their view.  The fund managers are now faced with a sudden and a very serious problem of plenty.  In the financial world, money cannot be kept idle even for a second; it has to invested immediately, in order to generate a return.  The market being high and prices being unreasonable, and yet burdened with excess funds that need urgent deployment, fund managers end up committing the same mistake as lay investors - investing at very high, unjustifiable and unsustainable prices. 

In the mean while, the print and television media pour fuel to the fire, by generating relentless noise in support of perpetual advance in the market – meaning prices of shares - like how the market is unstoppable on its march, predicting still higher market levels, and so on, roping in brokers and experts, who mouth similar platitudes.

Such a market condition provides a great and unique opportunity for the value investor to harvest his crop.  He sells his shares he had accumulated over a long period, at very low and attractive prices, during market lows, to the optimistic recent entrants.

As can be expected, following the general law of gravitation, which postulates that whatever goes up has to come down, the market rapidly melts down and eventually crashes.  There is a worldwide, general carnage.  The lambs are being slaughtered mercilessly, and there is nowhere to hide.

Greed is replaced with fear.  Both the lay investors and the fund managers panic and push the sell button hard.  The same media and experts, who till yesterday were praising the market, change tack and start spreading gloom, by highlighting the crash in horrific and graphic details, making references to the Great Depression of the 1930s, and so on. 

In the process of the market’s rollercoaster ride, thousands have destroyed valuable capital, decimated lifetime savings and their ancestral properties, and ruined their lives and those of their dear ones. 

Market at this juncture is unjustifiably low and shares of blue-chip companies are available at throwaway or very attractive prices.  The situation presents yet another unique opportunity to the value investor.  He pounces at it, and buys the same shares at very low prices from players who are extremely pessimistic about market.  The value investor might even have purchased from the very same pessimistic investor, to whom he had sold at very high prices, when that investor was very optimistic, not very long ago!