The human brain is wired for two things. One, it tries to identify patterns by scanning previous episodes and finding one from the past similar to the current situation. Two, from our ancient days, our ancestors have perfected a ‘fight or flight’ response when we encounter a ‘dangerous’ situation.
Our approach to investments in the stock markets where prices are displayed continuously on a monitor is based on the above approaches of the brain to a situation. When the markets are in a buoyant mood and everyone is soaking in stocks, the retail investor tends to jump in and invest in the market. When the markets take a turn for the worse, the same investor becomes nervous and decides to take flight at the first sign of trouble.
The herd tends to take the exact opposite approach of what would be ideal for the stock markets, which is to buy low and sell high. In the great boom of 2000 where there was a mad scramble for Internet stocks, Warren Buffet steered clear of hot technology stocks. For a couple of years he underperformed the stock indices by a large margin as the herd of retail investors pushed up the price of technology stocks to astronomical levels. The high reached by the NASDAQ index was breached again only in 2015. Several retail investors were wiped out in the ensuing technology stock meltdown. The same story has played out in India several times.
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The Reliance Power IPO is a case in point, where retail investors placed their bets in the IPO at high prices, but could not recover investments soon enough.
A successful stock investor must have the following qualities: principle defiance, ability to take intelligent risk and spot hidden value
Principle defiance means an investor is not swayed by market sentiments or by a person christened Mr. Market by Benjamin Graham. Mr. Market represents the mindset of the herd of investors. He should be able to hold his nerves when he believes that prices are not reflective of the fundamental intrinsic value of the stock.
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Most of us think of risk in terms of protecting one’s capital by selling stocks when Mr. Market is at his most volatile. When prices plummet we tend to sell at the point of maximum pessimism instead of plunging in to buy more. The biggest risk you can take is to miss your financial goals because you have been too conservative with you investments.
Finally, most investors do not look at the hidden value in a company, which is normally hidden in the unknown corners of an annual report. Often, it takes years for the market to identify that value. It takes a discerning investor to identify the value and go against the grain of the market. Such an investor makes enormous profits when the market recognises that value.
Hidden values come in three forms: Intellectual property rights that can yield useful royalty or brands that may be licensed out profitably; large tracts of real estate holdings which can be either be sold or developed successfully; subsidiaries that will generate huge cash flow in the future or can be sold for enormous profits. Mahindra & Mahindra, Tata Global, Exide Industries and Tata Motors are notable examples of such companies.
(The writer is an author and consultant)