Ask any veteran investor about his secret of investment and he will ask you to “Sell on greed and buy on fear”. If you look back at the markets over the last 10 years, this strategy would have precisely yielded rich dividends. Then why is that most investors and traders find it so difficult to sell on greed and buy on fear. For example, 2002 and 2009 were screaming buys for even the most naïve investor. Similarly, 2000 and 2008 were screaming sells even for someone with a very rudimentary understanding of the markets. Then why then did you not put all your savings into equities either in 2002 or in 2009?
Buying on fear and selling on fear is easier said than done. At the end of the day, initiating a trade may be an analytical game but sustaining the trade is, more often than not, a psychological game. That is where traders and investors falter and that is the reason selling on greed and buying on fear appears to be so difficult in reality. There are actually 3 reasons for the same...
In the stock markets, the easiest thing to do is what your neighbour at your apartment or your colleague in office is dong. 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 private banking stock at 60 times P/E and sold it off at 70 times P/E. This kind of peer pressure is hard to resist!
The bull market is likely to make you believe that the only way to make money is to keep buying like there is no tomorrow. Your intuition tells you that buying Wipro at 150 times P/E ratio in 2000 was a bad choice, but you still went ahead and did that because that is what every Tom, Dick and Harry on the street was doing.
At the peak of the tech boom, investors were told that technology would transform the world to the extent that electronic money will replace physical money entirely. Much later in 2007, we all believed that Unitech at Rs.25,000 per share was justified because real estate companies must be valued based on land banks rather than on sales and 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 numbers 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 10 years. As John Templeton rightly said, the most dangerous argument in capital markets is “This time it is Different”. It is this perverse argument that typically induces investors to keep buying aggressively at market peaks. When there is greed, you become greedy too and believe that this time something will be different. Of course, it is another matter that things rarely turn out to be different in practice.
This entire process is a vicious cycle. If you have been fearful at the top and sold off your shares then you will have liquidity at the bottom. The biggest reason for not being greedy at lower levels is that you just do not have liquidity on hand. You bought L&T at 6000 and do not have the heart to now sell it off at Rs.3000. So you hold on in the hope that you will eventually make a profit on L&T, which unfortunately never materializes. In the process you miss out on the salivating opportunities at the market bottoms.
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 is there not a solution to this problem?
The solution can come in the form of a disciplined rule-based trading. When you say rule-based, then it must strictly be rule based. 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!