“Be fearful when others are greedy and greedy when others are fearful.” — Warren Buffett
In February 2009, the Standard & Poor’s 500 index crashed to 735. When billions of dollars were fleeing the stock market looking for safe harbor, if you dared to put in $30,000 in the SPDR S&P 500 ETF (ticker: SPY), and hold it until today, it’s worth about $100,000, tripling your initial investment.
That’s the reward for your “greed” at a time of fear.
Conceptually, Buffett’s idea is simple and intuitive. When greed floods the market, stock is highly likely overpriced, then it’s rational to sell. When the market is replete with fear, stocks are undervalued and it’s good time to scoop up bargains.
[See: 8 Times When You Should Sell a Stock.]
In reality, the idea is extremely hard to implement. What it requires is not just an ability of “independent thinking” but also an iron will to act upon it.
You may not be able to tell when the market is too greedy. Market sentiment, like a pendulum, swings between overly optimistic and excessively pessimistic. At overly optimistic, stocks ratchet higher and higher, trading at a ridiculous level. The bubble will pop and stock prices will fall to reflect their intrinsic value.
Retail and institutional investors understand that and the urgency of exiting before the bubble pops. The catch is not knowing for certain we are in a bubble market — until it pops. Before the burst, one can always argue that the high prices were justified. During the dot-com bubble, many financial analysts believed the outrageously high stock prices were justified by the vast growth opportunities of internet companies. Since valuing growth potential is inherently challenging, that argument is hard to refute.
Greed is hard to harness. There are more naive greedy investors who are afraid that stocks will rise even more after they sell and don’t want to lose the opportunity to strike gold. So they hold on until it’s far too late.
There are shrewd investors whose greed is exacerbated by their overconfidence. During a bubble, these investors, despite knowing the stock is overpriced, don’t want to sell, because they believe there are bigger fools out there who would buy from them at an even higher price. Greed and overconfidence overthrow their rationality.
Fear is hard to fight. After the market crash, when you already lose one-third of your portfolio value, you are more vulnerable than ever and your desire for safety is stronger than ever.
[See: 7 Stocks That Soar in a Recession.]
Ironically, it is in this moment of rising risk aversion, Buffett recommends embracing risk and chase the upside potential.
How many people have the guts to double down when the markets are in a full-scale meltdown?
It’s hard to be fearful or greedy when everybody else is not. Can you convince yourself to buy when others are skeptical? What if that potential bargain stock turns out to be garbage — especially when everyone else is saying it is garbage?
Tesla ( TSLA) has appreciated over 30 percent in the past month. But you won’t be part of the rally if you listened to the conventional wisdom: the number of negative articles written on Tesla vastly outweighed the number of positive articles. No matter how strongly you agree with the vision of Elon Musk and believe in his ability to deliver on what he promises, the more you read the more you will doubt your instincts.
Human beings have an innate desire for harmony and conformity. It takes strict discipline and confidence to zig while others zag.
Is there a time that we should actually be fearful when everyone else is fearful? There are lots of suggestions on the internet about how to implement Buffett’s ideas. One of them is by looking for signs of “oversold.”
An often-mentioned technique measure is relative strength index, or RSI, and the recommendation to buy if the RSI index of a stock falls below 30.
The RSI compares the ratio of higher closing price with lower closing price to identify momentum. The oversold stock identified by RSI identify stocks that have more recent price-down days than up days.
Always use RSI with caution, because RSI tells you what happens in the past but nothing about the future. To justify a greed-driven buy, you need to be confident in the stock’s future, either in the company’s assets, executives’ vision, management skills and/or their business model. You will only buy because you think the price has been temporarily beaten below the fair value, not just because the price has been in decline. The price drop may be well-deserved and will not be reversed in the future.
[See: 10 Skills the Best Investors Have.]
For example, TripAdvisor ( TRIP) dropped by around 20 percent on its recent earnings announcement day. Just judging by this technique, you may conclude it was oversold. But a closer look suggests that despite the firm’s larger number of users, its management has still yet to find an effective way to translate subscription to revenue. And its updated lower price may well be their new normal until the company finds a way to boost sales.
More from U.S. News
10 ETFs to Buy for Aggressive Growth
6 Things to Know About Mark Zuckerberg’s Manifesto
The Value of Fear and Greed originally appeared on usnews.com
