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Stock market a 'Drunken Psycho'?

Jan 10, 2015

In this issue:
» Industries that will benefit most from GST
» Using the magic of compounding in creating wealth
» A round up of world markets
» ...and more!

Market participants take the stock market very seriously.

People day in and day out take most of their cues from what happens to the prices of the various companies in the market. So when XYZ Ltd's stock has gone up a whole lot and is trading at a rich valuation, they think - "XYZ Ltd. must be a very good company!"

And when XYZ Ltd's stock has just crashed 75%, they think "XYZ Ltd. is going into the ground! SELL SELL SELL!"

And there are a whole bunch of people out there that work very hard to ensure that you continue to take the stock market's prices very seriously. Investment bankers will point out to the rich valuations of already listed companies within a sector to convince you that the IPO of their company is most attractive. Brokers will point out to the 6 month price chart of a company to show you how the only direction a particular stock is headed is up. Companies will convince shareholders that the generous acquisition that they've just made is a steal considering what its peers in the market are trading at.

The list can go on. In fact, colleague and fellow editor of 'The Daily Reckoning' Vivek Kaul just yesterday wrote about the stories that business media and market analysts tell us.

So how much of your cues should you take from what happens in the stock market? Do you think stock prices give you a whole lot of information about what to do?

Fondly called the world's best investor, let's hear how Warren Buffett answered these questions in an interview in Detroit last month. "Mr. Market... he's kind of a drunken psycho", answered Buffett.

What! Did he say 'drunken psycho'? How can that be! And what about all the fuss that people make about stock prices being so important to your investing decisions?

"Pay no attention to headlines in the paper or people on television or anything", Buffett goes on to say.

Many will be quick to dismiss such advice as too idealistic, and not fit for the real world. So how far has Buffett reached with this kind of thinking? His net worth today stands at about US$ 73 bn. And he cites this as being the crux of his philosophy that helped him achieve such results.

Okay, so the stock market is a drunken psycho. So what should you do with this drunken psycho? Run away from him, like you would do if you met one on the road?

Far from it.

For this particular drunken psycho swings between being over-enthusiastic and hopelessly depressed. You take advantage of that. When he gets really enthused, you sell to him. And if he gets inconsolably depressed, you buy from him.

If there is any such thing as 'the secret to making money', that is it.

How much do you rely on the price action of stocks in the market while making your investing decisions? Let us know your comments or share your views in the Equitymaster Club.

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  Chart of the day
The Goods and Service Tax (GST) is one of the key reforms that will bring about a structural change in the economy. The implementation of the same is bound to bring more companies under the new tax regime, thus providing a level playing field to organized players forming part of sectors having a high proportion of the unorganized segment. As reported by the Economic Times, companies with turnover of more than Rs 1 m will now have to pay the tax; the figure earlier was Rs 15 m.

Sectors that may benefit the most from GST

As you can see, the chart above indicates that players from the footwear, plywood, textiles and sanitary-ware sectors are likely to be strong beneficiaries of this change. Battery as well as paint and adhesive manufacturers will gain from this move as well.

With news of this development coming in, stocks of companies that are slated to benefit from this change have been favored by market participants in recent times. Agreed that this structure is likely to bring in structural changes that will benefit organsied players over the long run. However, with the way markets have been running up in recent times, investors would do well to gauge the risk reward ratios of stocks that have already run up significantly - with the upsides seemingly being priced in already.

We are sure most of you have been asked a rather interesting looking mathematical puzzle at some point in your lives. It is about lilies growing in a pond. In case you've not heard about it yet, here it is. Imagine there are lilies growing in a pond and the total number of lilies double every day. So if you start with one lily on the first day, there are a total of two lilies on the second day, four on the third day and so on. Now, if the pond is exactly half full with lilies on the 20th day, how long do you think will it take for the pond to be fully covered with lilies? Most of us, who don't want to exercise our thinking powers too much, come up with an obvious looking answer of 40 days. The right answer on the other hand is it will take just one more day for the pond to totally fill up. Hence, the answer is 21 days.

You see, our brain is not exactly adept at grasping the power of compounding. It does very well in basic addition or subtraction, but when it comes to understanding the long term effect of compounding, it just doesn't come out intuitively. And this is exactly what happens when it comes to portfolio management. Honestly, even setting aside a small sum every month and letting it compound in high yielding asset classes like equities can make a huge difference over the long term.

Like this article in Live Mint points out, a corpus of 10 lakhs compounded at 7% over 30 years, will no doubt be 8 times more than what we started with. However, given that we have to account for inflation, it will just about ensure we have the same purchasing power as before. Now, the same money put in stocks and even after assuming a pretty achievable returns of 15% per annum, can help beat the earlier corpus by a factor of eight!

What happened here? It's simple. Like the lilies in the pond example, a portfolio compounding at 7%, takes around 10 years to double itself. On the other hand, the one compounding at 15% does so in just about 5 years. Therefore over a period as long as 30 years, while the first portfolio was up only 8 times, the second one compounding at 15% was up a whopping 64 times! So the key is to understand the hidden forces that work for you in the field of compounding and invest accordingly, we believe.

2015 has certainly not started on a positive note for global markets. The extremely sharp fall in crude prices has stroked fears of deflation in the developed world. This has also dampened expectations of an interest rate hike by the US Fed in the first half of the year. While the US economy continues to add jobs, the economic data still remains mixed.

In Europe, fears of outright deflation are now rampant. To add to the worries is the general elections in Greece on the 25th of this month. The vote could hasten Greece's exit from the Euro Zone if the left-wing Syriza Party were to win and form the new government. This along with the strengthening US dollar resulted in the Euro falling to a nine year low against the US dollar. European stock markets have understandably weak over the last month or so. Bond yields in the developed world fell to all time lows in the week gone by on deflation fears.

Barring a few stock markets, most ended the week lower. The French CAC index was the biggest loser while the Chinese markets continued its good momentum this week. Indian markets were down by 1.5% this week.

Performance during the week ended January 9, 2015
Data Source: Equitymaster & Yahoo Finance

 Weekend investing mantra
"I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful"- Warren Buffett

This edition of The 5 Minute WrapUp is authored by Taha Merchant.

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1 Responses to "Stock market a 'Drunken Psycho'?"

Yogendra Pal Singh

Jan 10, 2015

Well covered.

Equitymaster requests your view! Post a comment on "Stock market a 'Drunken Psycho'?". Click here!