The stock market’s short-term performance is heavily influenced by investor emotions. For example, many investors became fearful about the economy’s outlook and the prospects for a range of businesses in response to the start of the pandemic in March 2020. As a result, the S&P 500 shed nearly a third of its value in just five weeks.
Similarly, investors have historically become greedy during bull markets. Notably, valuations have previously risen to excessive levels during periods of stock market growth, including during the dot-com bubble and prior to the global financial crisis, as investors assumed that upward trends would continue indefinitely. However, no bull market has ever lasted in perpetuity.
Judging by today’s rich stock valuations, it could be argued investors are becoming increasingly greedy. This may lead them to overlook risks facing businesses and pay prices that are significantly above a company’s intrinsic value in the hope that they will be able to make a quick gain over the short run.
A structured approach
Baupost founder Seth Klarman (Trades, Portfolio) has previously discussed the importance of ignoring emotions when apportioning capital. Specifically, he has cautioned against investors becoming greedy. He said, "Value investors have to be patient and disciplined, but what I really think is you need not to be greedy."
In my view, using a structured approach to investing that relies on facts and figures is a simple means of avoiding emotions such as greed when managing a portfolio. A checklist that is consulted before any buy or sell decision is made forces an investor to consider specific company attributes, including its financial strength and valuation, before acting. This could make it easier for them to reject fear during a bear market and avoid the greed that is often prompted by large capital gains during a bull market.
A historical perspective
Investors may also wish to put the stock market’s recent positive performance into perspective. The S&P 500 has experienced 27 bull markets and 26 bear markets since 1928. On average, bull markets have lasted for three years and generated returns of around 110%.
Clearly, the current bull run could deliver a significantly higher return than past periods of growth. However, investors who compare their current gains with previous bull markets may find it easier to manage their expectations, in terms of how much further growth they are expecting. This may lessen the likelihood of them becoming greedy when managing their portfolio.
Furthermore, focusing on the stock market’s past performance may highlight the opportunities available to investors who can avoid a reliance on emotions. They may be able to use the greed and fear experienced by their peers to not only avoid today’s overvalued stocks, but to capitalize on undervalued stocks in the next market crash.
