It’s one thing to plan for a market crash but something else to live through a severe market decline and come out stronger than ever.
More often than not, investors lose hope during a bear market to the extent that they may even abandon equity market investments for a long period before getting back to markets exactly at the wrong time. Even though this phenomenon has happened throughout the last century, it seems as if investors are not learning from their mistakes and are hesitant to do the right thing when markets crash.
During these trying times, the best way an investor can focus on doing the right thing is by looking at how the legendary investors have achieved their success. Warren Buffett, arguably the most successful investor in history, once said, “One simple rule dictates my investing: Be fearful when others are greedy and be greedy when others are fearful.”
It’s no secret that there’s plenty of fear right now in the market. Therefore, it seems this is a good time for value investors to be greedy. However, this is easier said than done. In this analysis, we will look at what I think is the correct way to be greedy during a market crash and highly volatile conditions.
The cycle of emotions
The first important thing is to have an understanding of the cycle of human emotions. According to behavioral finance studies, investors tend to base their investment decisions on emotional factors more often than they realize. For instance, when stock prices are soaring, investors feel a false sense of security as the media reports these numbers in a manner that attracts new investors and boosts confidence in capital markets. Such actions, however, could lead to dire circumstances.
The below is an illustration of the cycle of investor emotions.
Source: Abor Investments
As illustrated above, at the point of maximum financial risk, investors are usually in euphoria, which leads them to assume that risk and invest in all the "hot" stocks that could double or triple in value in a couple of months. However, this could wipe out the entire portfolio value in a matter of a few days.
This is true for the other side as well. At the point of maximum financial opportunity, most investors opt to remain oblivious and wait for "better opportunities." There’s a simple concept underlying this cycle of emotions; when stocks are pricey relative to their earnings, investing in them can lead to an erosion of wealth when markets crash.
Learning from the history books
History may or may not repeat itself, but the lessons that an investor can learn by analyzing historical market trends and performance are invaluable. Therefore, it’s important to validate whether being greedy when others were fearful has been a successful strategy.
The dot-com bubble in 2001 and the financial crisis in 2008 are two of the most catastrophic market events that wiped billions of dollars off capital markets in this century. As daunting as these events might sound, an investor would be surprised to know that some of the best investment opportunities emerged during the turbulent times created by these market downturns.
When the dot-com bubble crashed, tech stocks declined to historic lows. Most investors conclusively decided that it would be a bad idea to invest in tech stocks. However, since then, some of the best-performing companies have been tech stocks such as Apple Inc. (AAPL, Financial), Amazon.com Inc. (AMZN), Netflix, Inc. (NFLX, Financial) and Facebook Inc. (FB, Financial). If an investor decided to ditch the tech sector entirely, the opportunity cost of such a decision would be substantial. As illustrated in the below chart, the tech-heavy Nasdaq index has handsomely outperformed the broad market since 2002.
Source: Yahoo Finance
The same is true for the financial services sector as well. Even though many well-known banks and financial sector companies were facing the risk of bankruptcy during the financial crisis, most of these companies have provided stellar returns to investors since then. The big banks have grown in stature, boosted their dividend payments and distributed billions of dollars to investors through share buyback programs as well. Warren Buffett (Trades, Portfolio), in 2008 and 2009, invested billions in The Goldman Sachs Group, Inc. (GS, Financial), Bank of America Corporation (BAC, Financial) and JPMorgan & Chase Co. (JPM, Financial), which have proved to be value-accretive investment decisions in the last decade.
In an article titled “Buy American. I am," published in The New York Times in October 2008, Buffett outlined his investment decision-making process.
“Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month or a year from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over. A little history here: During the Depression, the Dow hit its low, 41, on July 8, 1932. Economic conditions, though, kept deteriorating until Franklin D. Roosevelt took office in March 1933. By that time, the market had already advanced 30 percent. Or think back to the early days of World War II, when things were going badly for the United States in Europe and the Pacific. The market hit bottom in April 1942, well before Allied fortunes turned. Again, in the early 1980s, the time to buy stocks was when inflation raged and the economy was in the tank. In short, bad news is an investor’s best friend. It lets you buy a slice of America’s future at a marked-down price.”
Clearly, Buffett is a fan of investing during difficult times for the market and he has benefited from these types of investments for the best part of the last five decades.
The most important lesson for an investor, therefore, is that short-term market volatility and declines should not be allowed to cloud the judgment of investors. As evident from the above examples, which the success of the likes of Buffett confirms, an investor would be better off keeping a straight and cool head and shopping for bargains in equity markets when others are in flight mode.
How to be greedy the right way
Even though empirical evidence suggests that investors should be buying, not selling, when markets are crashing, this has to be done carefully so as not to be the victim of value traps. A value trap, by definition, is a company that is trading at depressed valuation levels but for all the right reasons. Therefore, an investor needs to avoid these types of companies at any cost.
Being greedy does not mean falling victim to the seemingly attractive valuation multiples of depressed companies. The correct way to shop for bargains is to find companies that are projected to grow in the future and then determine whether the current market price represents an anomaly between the share price and the economic reality of the company. Also, it’s important to bet on companies that have a strong and trusted management team.
One of the best ways to do this is to look at how a certain company has performed during past recessions and assess whether the financial performance has recovered along with the economic growth that prevailed beyond the recessionary period. A company that has done it once is in a better position to do it again and it speaks of the ability of a company to remain solvent during difficult times.
One of the other things an investor should pay close attention to is the balance sheet health of a company. Even if it’s a high-growth company, a poor balance sheet is a warning sign because the company might collapse before the economy recovers.
An investor who pays attention to all these factors could easily be able to find companies that fit this description. Finding such companies will pave the way to generate very attractive returns in the long term.
Disclosure: I own shares of Facebook.
Read more here:
- The Market Could Head Higher Despite the Contraction in GDP
- The Dollar’s Plunge Calls for Tactical Asset Allocation Decisions
- Why Bank of America Is Not for Every Investor
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