Stock Market Crashes
and Stock Market Bubbles
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Lesson 10 Objectives
Lesson Objective 1: Introduction to Fear and Greed Cycles
Lesson Objective 2: Warren Buffett's Opinion on Market Psychology
Lesson Objective 3: Accumulating Shares Vs Trading Shares
Lesson 10 Executive Summary
In this lesson, we learn about human instincts. One might think that we, as people, react on the basis of experience and knowledge and while this is true, we also react on pure instinct and that instinct is present more than anything else in the stock market.
As for the stock market in the short term (below 3-4 years) it is important to understand that the investors follow the instinct of Mr. Market. In other words, investors react on emotions and people are chasing prices – not value.
Warren Buffett has strong opinions on market psychology. He is quoted to say “Be fearful when others are greedy and greedy when others are fearful.” In order words, what he means is that an investor should accumulate shares when prices are low and sell or at least not buy when prices are high.
We learn about a value-based approach to investing. That is when you look at the financial properties of a stock and have a firm idea of its intrinsic value. A value-based investor’s mindset is to profit from accumulating stock. The larger the discrepancy between price and value, the more wealth you can accumulate over time. It is a buy and hold strategy.
On the contrary, we also learn about the emotion-based approach that is only based on the perception of the stock, but has no reference to the actual value of the stock. An investor that bases his investment decisions on emotions ends up trading stocks. He typically ends up with fewer shares bought at a higher price. It is a buy-sell strategy.
A prime source of different approaches to stock investing, which I personnally read and enjoyed, was The Neatest Little Guide to Stock Market Investing by Jason Kelly. In addition to a detailed overview of stock investing approaches he also provides a simple tool for composing a watch list for the stocks you consider buying. Be sure to check out the reviews on Amazon to see third party endorsements and concerns before simply taking my recommendation.
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When people think that it’s easy to make money by entering a market that has been increasing for a long time in the anticipation that it will continue to increase, they are not looking at the value of the stock, they only observe that the price has a history of increasing. This is known as the greed cycle.
When people see that the market is dropping and start to sell their own stocks, the mindset is centered on the fear of losing money in the short run, and not whether the price of their holdings is lower than their value.
A value-based approach is an approach an investor adopts when he estimates the value of a stock and buys it at a cheaper price. It is a buy and hold strategy that accumulates shares of a low price and high value.
An investor who adopts the emotional-based approach has no estimation of the stock value. This investor buys stocks, based on his preference and perception that might not have any relation to facts. He buys and sells stock arbitrarily and typically ends up with fewer shares bought at a higher price with a low value.
Stock Market Crash - Lesson Transcript
Imagine you are standing on a city just minding your own business when all of a sudden, you see a rampage of people running down the street directly towards you. You have very little time to react, but if given the time, how would you react?
Most people would probably turn in the same direction and start running with the others, while some would ask why they are running, where they are running to, or what they are running form. Your natural instinct is to turn with the people and start running. You might not know why, but your instinct tells you to keep moving as you don’t want to continue standing there.
Let’s take another example. Let’s imagine that you rent a car and are also looking for a place to stay at night. You drove past a night club named “Best Night Club on the Planet”. You see a long line of people standing there just waiting to get in. What would be your natural inclination? Lot of people would see the long line and think, “This night club is awesome and probably one of the best places to get in!”
The first scenario is something fearful – you were standing on a street when people come running towards you. The second scenario is greed – you saw a group of people standing in line waiting to get in. These are instincts. An instinct is described as, “Any behavior is instinctive if it is performed without being based on prior experience or knowledge.” Two words to highlight are ‘without’ and ‘knowledge’.
I gave two examples of everyday occurrence so people could really quickly relate to it. A lot of people forget how markets move in the short term. Short term means a couple of years. Three to four years is considered short term, while twenty-five to thirty years is long term.
When talking about how the market moves in the short term, you need to understand the fear and greed cycles. The scenario with people running down the street is the fear cycle. The greed cycle is lining up in the bar to meet fancy people and have a great time. This makes you remember Mr. Market, doesn’t it? He gives clues to be an instinct-based trader and since most investors invest in stocks, based on their emotions and instincts, they fall to the mindset of Mr. Market. Instinct isn’t based on knowledge. The solution is to be knowledgeable by basing decisions on facts, rather than getting fooled by emotions.
Mr. Market yells, “Come, I’m making money! You can make money! My neighbor can make money!” His mindset during the greed cycle is that a quick buck can be made using little effort. You have traders who get in for one day, make 10% on the stock, quickly sell it, and think “I’m going to send another one! They make some more money on that.” The next thing you know, they’re doing it day in and day out. They’re making some money with it. The market cracks because you have value-based traders who actually know what value those assets have and they start trading down because they’re too high. What comes next is the fear cycle. People start getting scared because though they were losing a small amount of money in the beginning, they start losing more money as time goes by. Most people get scared at this point. The mindset now shifts to making a quick buck. They sell all their shares and realize they lost much more than the meager amount of money they made. They lost more than what they initially started out with.
How do we know what the stocks are worth? If we know the stocks’ worth, we know if the price is overvalued or undervalued. We need to know the stock value.
Warren Buffett’s opinion on this market psychology is this: “To be greedy when others are fearful and to be fearful when others are greedy.” The name of the game is to really accumulate shares versus trading shares. You want to be the person who accumulates shares.
Benjamin graham has a wonderful quote that says, “The stock market behaves like a voting machine, but in the long term it acts like a wind machine.” It means in the short term, the can price can increase by $10 or $15 a stock (it depends), but in the long term, the stock will be worth what its value is. That’s when the value becomes absolute.
Here are two different traders – value-based and emotion-based approach. Our value traders, Amy and Trevor, are typical traders who might not really understand all the different financial terms and everything there is to stocks.
We have Amy buying a stock at a company called “American Eagle”. Just so you know, the numbers quoted are not real stock numbers from American Eagle. Amy would look at American Eagle and read through all financial debts. The company’s earnings are $2 a share, and the $18 book value is a great margin of safety. The 1% dividend is okay. Overall, its intrinsic value is $22 a share.
An emotion-based trader would think, “Wow, I really like American Eagle. I have tons of their clothes. They’ve got stores in very mall and every kid in high school shops there. They opened a new store in the next town over. I’m going to buy stocks.” That’s how Trevor thinks.
Amy now buys 100 shares of American Eagle for $20 a share, so that’s a 2,000-dollar investment. Trevor does the same.
In this scene, the market goes down and the shares are not trading for $20, but $15. This is how Amy would think: “The earnings are fewer than what I had originally hoped for, but it’s still worth at least $20 a share, and since it’s trading for $15, I better get some more to get a good price.” Amy is looking at this saying, “Wow, they have a little less in their last quarter earnings than they’ve reported, but the company is still worth $20 which is little bit less than what I thought before.” Since they’re trading for $15, she will get more because she knows it’s for a deal.
Now Trevor says, “Oh, no! What in the world did I get myself into? I just lost $500. American Eagle is a great company. How could it go down so much? I might need to sell it because it might get even lower.”
Look at their different reactions. Amy invests another $2,000 and gets 133 shares, because the market price is cheaper. Now she owns 233 shares of the company. We look at Trevor and he’s going to hold on to his 100 shares. He’s nervous because he lost quite a bit of money.
Let’s just say another 6 months go by, and the stock is still trading down to $15 range. Amy’s mindset is, “I can’t believe people are still trading this company for $15.” She’s getting a bit frustrated. It’s now $21 a share, based on the new earnings and balance sheets. She buys another 133 shares for $2000. Amy now has 366 shares.
Although the stock is still lower than what she expected, sometimes you wait for a company years before they actually come back to that intrinsic value that you might think it is worth. The key here is to think for yourself and absolutely know that you’re calculating the value properly and that you’re looking at the variables right. Amy buys more shares for $15, while Trevor is still nervous and cannot believe that their shares have gone down, so he continues to hold it.
Let’s say that it’s another 36 months or so. The market price goes back up to $24 a share – $4 higher than where they both started. Amy says, “It’s trading for more than I thought its worth, so I’ll buy somewhere else with a good buy.” She thinks it’s overvalued. She’s invested $6,000 profit, because the stock is back to $24. She’s made $2,784 on a 48% gain.
Now Trevor says, “Sweet! I knew this was a great company! I just made some easy money! I’m going to buy more! He’s going to buy more of the $24. He made $400 profit on this $2,000 investment. This is truly the difference between a value-based investor and an emotional-based investor, because a value-based investor looks at the company’s financial debt versus somebody who bases their decision completely on their emotions. The saying goes, “Buy low, sell high.”
When you look at these two scenes, Trevor was always buying when it was high. Amy was always buying when it was low. Whenever the price got higher than her expectations, she stopped buying and held on to her shares.
So, what kind of trader are you? Do you typically sell like Trevor or like Amy? That’s something you have to decide for yourself. Decide also whether you think that’s the right approach for you. Maybe it’s not.
In the long term, who do you think is ultimately determining the market price? Is it Amy or Trevor? In the short term, Trevor is controlling the market price. Other people similar to Trevor in the world make it go up and down, because they are trading on emotion. They are falling to Mr. Market. In the long term, Amy is the person ultimately controlling the value of the company.
If you’d like to trade shares like Amy, then it requires knowledge not instinct. If you’re looking to do that, you’ve definitely come to the right site. We’ve got lots of tutorials to help you how to be a knowledgably investor. And value based investor. Course 2 will teach you.
In this lesson, we learned about the psychology of the stock market and how most traders rely on instincts opposed to value in order to conduct trading. We learned a very important quote from Benjamin Graham that states, "The stock Market behaves like a voting machine, but in the long term it acts like a weighing machine." This idea is important for value investors to understand as they remain confident in their valuation of any asset during emotional times.
During this lesson, we provided a demonstration of an emotional trader and a value trader. As you could see in the video, the value trader almost always had the opposite opinion of the emotional trader. This is important to remember as you move into the second course of this website. Determining the intrinsic value of a stock will help provide a peace of mind and ability to make clear decisions.