What’s important to understand is that at the beginning of any major decline, the market will have some fundamental reasons to fall. After a while though, fear and only fear becomes the prime reason driving the market down.
KSE100 has been falling for the past two weeks now – So what better time to write up on fear and understanding how to play it?
If I have to think like a scientist and dissect what’s going in a person’s mind when the market is coming down, I am sure to find the following stream of thoughts:
- Some bad news has come that is impacting the fundamentals of the companies you own (let’s call it the fundamental string)
- Secondly, fear kicks in when you see the market falling down continuously. One wonders how much further would it come down (this is fear)
Combine these two and you have a sum of the total decline.
Obviously, there is no way to figure out how much these factors contribute to the decline exactly. But being an investor and working alongside them for over a decade, I can take the liberty to say that determining the dominant factor behind the decline is possible, at least instinctively.
And why is it important? Because if we can understand the drivers of fear rightly and how are they at work – we can unlock investment value. Let us explain
Scenario 1: When fear is low
Usually, investors are more confident when they have made good money in the recent past, even in times of market corrections.
Say the market falls by 10% but in the recent past investors have made say 20-30%. So, they will be less worried and keep their optimistic bias on the future.
In such cases, the decline in stock prices is small and non-contagious as is the opportunity to make money. You might at best get a 5-10% drop in value for stock so the best way to capitalize this is to average what you have (you might consider leverage here).
Scenario 2: When fear takes over completely
But the emotional attitudes towards the market change when investors haven’t made a lot of money in the last few years. The decline becomes contagious and emotions kick in.
Take the example of Covid-19, investors succumbed to the fear of the unknown and got into panic mode – selling everything at whatever prices available.
But this can be a time of extraordinary opportunity for those who can keep a cool head. If done the right way, you will have a portfolio of great companies at rock bottom prices. It’s like choosing the most valuable items on a Black Friday sale.
Say the overall stock market or some sectors have fallen by 40% but when you actually quantify the impact, by doing your own analysis or reading research reports, the impact is 15%.
So, what is this additional fall of 25%? It’s basically all fear and sooner or later when things settle, this 25% will be back. Had you overcome fear and invested in strong growth companies then, you would end up making good money.
In such a scenario, try overcoming fear and work on finding strong companies that can survive the downturn rather than predicting market movements (read more to find out how useless can it be).
The market is not a mechanical machine, it’s a place where emotions interact. And investing is not a science but art. We talked about the fear part since markets are falling but it works the same way when it goes up.
Have you seen global analysts changing their forecasts for say commodities when they are in the bull cycle? Or local analysts coming out with target prices that are too good to be ignored in a bull cycle? That’s where fear is completely replaced by greed!
A disciplined investor would harness an ability to see through both fear and greed.
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