The legendary Warren Buffett once said that "The best way to make money in equities is to be fearful when others are greedy and to be greedy when others are fearful." While this sounds quite logical it is hard to practice in reality since most investors tend to be swayed by emotions and peer-pressure during the peaks and the troughs of the market. Let us take the previous such cases in India when such a contrarian approach would have really worked in your favour.
Back in September 2001, the Indian markets were extremely jittery. That was the time to be greedy in the markets. The Sensex had crashed to around 2700 (yes, Sensex you heard it right) in the aftermath of the 9/11 attacks on the Twin Towers. But that was also a bottom that has not been revisited in the last 16 years, and perhaps never will be. Similarly in early 2008, the signs of over exuberance were all over the place. That was the time to get fearful in the share markets. While we understand that buying in the midst of fear and selling in the midst of greed is hard, the question is whether there is a systematic and logical way to approach this problem.
Learn to think logically and, therefore contrarian..
Being contrarian is not rocket science. It is all about thinking logically. Let us look at this problem differently. Why do we rush to ecommerce websites like Flipkart and Amazon during festival season? Why do we wait for year-end discounts to buy our preferred brands? The answer is very simple; we see great value in getting the same product at a discount. Unfortunately, we never apply the same logic to buying stocks. When we do not pay an unnecessary premium for our regular shopping there is no reason why we should pay an unnecessary premium while buying stocks. When you can get the same L&T and HDFC Bank at much lower valuations, why do we not rush in and buy. Once we can understand this similarity between buying goods and buying stocks, it becomes so much easier to be contrarian and be greedy when others are fearful.
Adopt a P/E range approach..
This is a more scientific method of buying low and selling. In others words, it helps us to be greedy when others fearful and be fearful when others are greedy. How does this work? This is basically a portfolio allocation based approach and hence rule-driven. Over the last 25 years the markets over the longer term have ranged between a P/E of 12X and 27X. These two ends represent the levels when you must get greedy and fearful respectively. If you adopt an allocation based approach, you will automatically shift out of equities into debt closer to 27 times earnings and shift from debt to equity closer to 12 times earnings. Remember, in both these cases it is impossible to catch the bottoms and the tops. In fact, it is not even required. If you can just ensure that you are have the liquidity and are able to buyer at lower valuations, you are likely to be on the right side of the market.
Avoiding the liquidity (cash on hand) trap..
What exactly is this liquidity trap? Envisage a situation that you had bought a stock like SBI its peak in 2010. After 7 years the stock is still well below your purchase price. What has happened in the process is that you have stayed invested in the stock for 7 long years but in the process you missed the market bottom of 2011, the crash of 2013 and the budget day bottom of 2016. Most of the stocks have multiplied manifold from these bottoms and you could have possibly participated in these stocks if you had sufficient liquidity at your disposal. That is where a disciplined P/E approach can be of some help to you. Alternatively, if you are convinced that there is something structurally wrong with the stock as was the case with capital goods a few years back and as is the case with banks today; then just exit the stock even if it means a loss. At least, the liquidity availability at lower levels will open a wide array of opportunities for you to participate in. More often than not, it is lack of liquidity that prevents you from being greedy when others fearful.
Get over that "This time it is different" syndrome..
Sir John Templeton had once said that "The most dangerous argument in stock markets is that, this time it is different". We have seen these arguments so often. At the peak of the technology boom in 2000 and the sub-prime boom in 2007 most investors kept on buying at higher levels believing that this time it was different. Similarly, at the bottom of the market in 2001 the view was that the end of the world was approaching and there was no point in buying. Historically, the argument that this time is different has never worked. Eventually, stocks will gravitate towards the rational median and that that is why it is so important to be greedy when others are fearful and to be fearful when others are greedy.