Value Investing and Behavioral Finance
the companies trading on the bourses. This has created huge wealth for
the shareholders as a whole.
A natural consequence of an extended bull market is the shift in the
risk-reward ratio on opportunities available in the market. Before the
onset of the bull market, when in a bear (or consolidation) phase, mass
psychology makes people fixated on the risk, all the time, without
comparing the huge rewards that are there to compensate for the risk
taken. As the bull phase progresses and the inherent risk factor increases,
the mass psychology being totally fixated on recent rewards achieved by
investors, loses its focus on the inherent risk quotient of the markets.
Here we have a classic case of mass psychology leading to mis-appraisal
of the tisk-reward ratio, inbuilt in the stock valuations, at various stages
of the market cycle because of behavioral anomalies leading to ex:
and resultant painful contractions leading to great losses to people who
forget to think in terms of the inherent tisk and reward factors of an
opportunity. It is no different in this bull market also.
AS a contrarian investor—whom the legendary investor, Warren
Buffett, appropriately defined as somebody who gets greedy when others
are fearful and one who gets fearful when others are greedy—one should
not forget the important principle of comparing the reward against the
risk, while making investment decisions.
In effect, as the market and stocks start to fully discount the
fundamentals of the business and future prospects, one would do well to
shuffle one’s portfolio by replacing stocks with deteriorating risk-reward
ratios with opportunities that offer attractive risk-reward prospects. This
involves constantly looking for businesses where the true value of the
business is not fully reflected in the stock price. This approach of striking
the right balance between price and value involves betting against the
conventional wisdom because if conventional wisdom followed the same
principle, investors would end up driving markets to become fully efficient;
i.e. every business would be valued appropriately based on its underlying
fundamentals and expectations to deliver risk-adjusted rate of return.
But as long as mass psychology drives the market, there are going to
be areas where the businesses will be mispriced, and the prospects of
carning an above-average return will exist. One of the best places to look.
for such mispricing, led by mis-appraisal of a security, is the ‘52-weeke
78