When Rajesh started online trading and investing in 2007, he almost appeared to have acquired the “Midas Touch”! Every realty and infrastructure stocks that he purchased appeared to be giving 25% returns in less than a quarter. By early 2008 Rajesh was confident that he had cracked the secret code of investing and decided to create a huge portfolio in early 2008. Unfortunately, markets went into a downturn after that and his portfolio of blue chips had lost nearly 60% by early 2009. Sub-prime and Lehman had inflicted damage. By February 2009, Rajesh was so frustrated that he decided to book a loss on his equity portfolio and shifted all his funds to safe G-Sec funds.
Where did Rajesh go wrong?
If you were to sum up the example of Rajesh in a nutshell; he first became greedy at a time when he should have been fearful and eventually ended up being fearful when he should have actually been greedy. He was willing to buy stocks at 29 times P/E but the same stock, he was unwilling to buy at 12 times P/E. Remember; nothing changed fundamentally about these stocks during this period. The question for Rajesh is not to avoid fear and greed. They are necessary psychological ingredients of trading and investing and you cannot wish them away. The real answer lies in being greedy at the right time and being fearful at the right time. One can argue that this kind of approach is easier said than done, but there is a methodical way out. In fact, there are five steps that you can keep in mind to ensure that fear and greed is channelized at the right time.
Separate emotions from your decision
This is the hallmark of successful traders and investors and it is called a counter-intuitive approach. This approach is based on the assumption that you can never make profits in the market by running with the herd. Herd mentality can never help you to make smart entry and exit in the stock markets. Being counter-intuitive has an important implication because your emotions are separated from your judgment. Thus you can run profits longer and cut losses shorter. Also you can smell opportunities when they really arise. For example, had you bought stocks at the bottom of 2003, 2009 or 2013, you would have really accumulated multibaggers along the way.
Using the market P/E and compare with historical average
This may sound like a fairly simple and primitive method but it rarely fails. If you buy quality stocks when the Sensex P/E is at 12-14X, you would have rarely lost money. Similarly, if you buy stocks at P/E of 26-28X, it is very difficult to make money. In other words, you must be greedy when the market is fearful and you must be fearful when the entire market is being greedy and optimistic.
A clearly laid out exit strategy can be quite useful to you
A smart investor or a trader always operates in the market with an exit strategy before they buy a stock. This way they know where they are going to get out if the market moves against them, and how much they are going to lose if wrong. The advantage here is that you can set your losses based on how much capital you are willing to risk in the trade. An exit strategy also brings about discipline.
The longer you stay invested, the better your profit chances
When the tech meltdown started in 2000, Infosys lost nearly 80% of its value over the next 6 months. However, over the next 8 years the stock not only recovered these losses but also gave stupendous returns from the previous peaks. That is the power of long term investing. Of course, not every stock can be an Infosys but it is possible to have a better chance of avoiding the fear / greed debate if you have a solid long term perspective. As Warren Buffett would say, Investing has to be forever.
There is merit in planning and asset allocation
One of the big advantages in any plan is that your distribution of equity and debt is determined in advance. When prices go up and equity becomes more valuable, then the ratio goes up and you need to exit at higher levels to bring the ratio back. This not only ensures that you book profits automatically at higher levels but also ensures that you have the requisite cash available with you when the opportunities arise at lower levels.
There is no rocket science here. You just need to be counter-intuitive and ensure that your fear and greed are driven by rational thinking than by the herd mentality. The profits will automatically follow.