Benel Lagua l October 27, 2023 l The Manila Times
HERE’S a timeless quote from Warren Buffett. “Occasional outbreaks of those two super-contagious diseases, fear and greed will forever occur in the investment community. The timing of these epidemics will be unpredictable. And the market aberrations produced by them will be equally unpredictable, both as to duration and degree. Therefore, we never try to anticipate the arrival or departure of either disease. Our goal is more modest: We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”
In his 2005 report to stockholders of Berkshire Hathaway, Buffett reminisced on how 2004 was a non-normal year with the S&P 500 index reflecting a 10.9-percent return. In fact, he asserted that over 35 years later, investors would have earned juicy returns simply piggybacking on corporate America by investing in a diversified, low index fund. Instead, many investors had mediocre to disastrous results.
Buffett attributed the negative results to three primary causes — first, high costs, usually because investors traded excessively or spent far too much on investment management; second, portfolio decisions based on tips and fads rather than on thoughtful, quantified evaluation of businesses; and third, a start-and-stop approach to the market marked by untimely entries (after an advance has been long underway) and exits (after periods of stagnation or decline). Investors should remember that excitement and expenses are their enemies.” This is the context for the fear and greed proposition.
Fear and greed are the two powerful emotions in stock market investing. They are among the animal spirits Keynes identified as affecting economies and markets. Buffett’s investing view proposes a contrarian approach to such prevailing moods. He used the overall market capitalization-to-GDP (gross domestic product) ratio to gauge the relative valuation of the US stock market, whether it was expensive or cheap at any given moment. In the “Buffett indicator,” if the percentage relationship falls to the 70 percent or 80 percent area, buying stocks would work well. But reaching high levels of up to 200 percent is like playing with fire.
A dictum in finance says what you cannot measure cannot be controlled. The Buffett indicator has seen several enhancements. One of the more popular these days is the CNN fear and greed index which seeks to determine the emotion driving the market. When the S&P 500 is above its moving or rolling average of the prior 125 trading days, that’s a sign of positive momentum. But if the index is below this average, it shows investors are getting skittish. The fear and greed index uses slowing momentum as a signal for fear and a growing momentum for greed. As of Oct. 16, 2023, for example, the index shows fear compared to extreme fear a year ago.
An interesting question posed by Geoffrey James in CBS News “MoneyWatch” is which motivates customers better? According to James, the correct answer is fear. Human beings are much more motivated to avoid pain than to seek out pleasure. Because of that fear has much more power to motivate than greed, or indeed any other emotion that’s concerned with pleasure.
Many investors are emotional and reactionary, and fear and greed indicators can be used to temper one’s emotion and biases. One should try to understand the dominant emotional motivation. It is beneficial to be wary of the madness of the crowd. Assess market sentiments and combine this with fundamental and other analytical tools. Investors should aim to acquire, at a sensible price, a business with excellent economics, able and honest management, and quality earnings potential that are virtually certain.
The aim is to be a rational investor, someone who is sensible and can make decisions based on intelligent thinking and verifiable data rather than on emotion. This requires discipline, a lot of patience and courage in the face of volatilities. Of course, it’s an ideal worth aiming for because the harsh reality is that we will all be tempted to act from either fear or greed.
Benel de la Paz Lagua was previously EVP and chief development officer at the Development Bank of the Philippines. He is an active Finex member and an advocate of risk-based lending for SMEs. Today, he is an independent director in progressive banks and in some NGOs. The views expressed herein are his own and do not necessarily reflect the opinion of his office as well as Finex.