Keep Your Head

Now that the markets are floundering seriously, investors must avoid panic and remember the real lesson from past crashes

Back in January 2008, when the initial equity crash of the financial crisis had just happened, there was a news story that in Ahmedabad, policemen had been deployed on some lakeshore to prevent suicides. Don't know what became of that, but investors would be wondering whether that stage would be reached this time around.

There are any number of quotes, sayings and aphorisms that will tell investors what to do--or at least, what to think--when the stock prices are crashing. A typical one would be, 'I've found that when the market's going down and you buy funds wisely, at some point in the future you will be happy', which was said by the great investments manager Peter Lynch. Or the famous 'Buy when there's blood in the streets, even if the blood is your own,' attributed to the 18th century Baron Rothschild of the Rothschild banking family.

What they're telling investors is that the best time to buy stocks is when the equity prices are down. This has to be the most obvious idea in investing. In fact, it has to be the most obvious and the simplest idea in buying anything at all. If you are buying anything at all, surely it is better to buy when it's cheaper. It's often pointed out that we do this all the time in everything else we purchase. We wait for sales and we flock to shops and websites running discounts. And yet most buyers' behavior is the opposite when investing in stocks. They rush to buy when prices are going up and sell when they are going down.

Actually, this isn't much of an anomaly. Our behaviour for things that we consume and things that we intend to trade are bound to be different. We buy stocks with an intention of selling them later. The utility that we expect from the stock of a company is the price that we sell it at. In a bull market, we come to believe that that utility will be much greater in the future, so we rush to buy when the stock. In bear markets, the opposite is true, as is the case nowadays. In a way such behaviour happens while purchasing anything. If a pair of trousers is at a 20 per cent discount, you will not buy it if you expect the discount to increase in the near future. You are still driven by the gap between the utility you will get and the price you will pay.

However, even if there's a logical explanation for such behaviour, it doesn't mean that it's not wrong. This behaviour is driven by a simple linear projection of the recent past into the foreseeable future. If stock prices rose over the last few weeks or months, then they will go on rising. And the opposite, of course. This is not just simple but even simple minded. In reality, when stock prices fall, it always raises the probability that they will start rising. And the more they fall, the greater the rise will eventually be.

Is this just a something people say? No, in fact it is provable by data.

Recently, there was a very interesting study that quantified this rule over the entire history of the Sensex.

The returns of the Sensex was  calculated every month for every period from the previous one month to the previous 60 months. Also the returns of the Sensex going forward for five years from each of these points (there were a total of 24,360 such points over the entire history) were calculated . And then we collated this data and looked at the patterns. It turns out that if you summed up all periods where there had been a decline of  5 to 40 per cent in the Sensex, then the likelihood of the Sensex being higher over the next five years went up from 88 per cent to 100%. The median return over the next five years ranged from 80 per cent to 292 per cent. Essentially, if you buy the Sensex after any kind of a decline--even a moderate one of 10-20 per cent, then you are pretty much certain of making a substantial amount of money over the next five years. So as the blood on the streets runs thicker, you know what to do.