“No one ever went broke taking a profit.”
— Bernard Saruch
Over the course of history, the financial markets have always experienced periods of extreme volatility. Although one can come up with hundreds of reasons — some very simple, others very technical — to rationalize the market’s movement, there are really only two factors. Fear and greed. These two human emotions can cause markets to skyrocket to stratospheric levels and then change course and plunge to crashing new lows. Having been a bond trader on Wall Street for many years (and also having a minor in psychology), I can testify firsthand to the validity of this phenomenon. I am sure almost everyone can tell a story of a stock they purchased at $15, watched go up to $50 and then come down to $10, where they still own it. If not, then certainly the opposite situation of the stock purchased at $30 that promptly plummets to $10. After an interminable wait, you finally decide to sell it to avoid any more pain, only to watch it triple or quadruple a short time later. Think back to what you were feeling when any of these scenarios happened to you. Institutions and large corporations are no less vulnerable. Even though institutions have sophisticated computer systems to govern trading decisions, the human beings who run these systems are ultimately accountable for their actions.
It is these emotions of fear and greed that cause market moves to become exaggerated in either direction. One other emotion I have yet to mention is hope. That’s what happens in the preceding example, when you hold your $10 stock forever, hoping it will go back up to break even.
Although fear and greed can be very profitable if taken advantage of properly, hope is usually a losing proposition.
Now that we understand the psychology of the markets, let’s see how we can take advantage of all this volatility to make a profit. As a trader, you can make or lose a lot of money in these markets, and it can make you crazy, but from an investor’s standpoint it can be the best thing that ever happens. We used to have a couple of old expressions on Wall Street, “… buy ‘em when there’s blood in the streets,” and, “… feed ‘em, they’re hungry?’ In other words, take advantage of these market moves to buy some quality stocks that were too expensive before, and sell off some shares in stocks that are over-priced. If there is one thing you learn about the market, it’s that things always get overdone, on the upside and the downside. As financier Bernard Baruch once said, “No one ever went broke taking a profit?’
This same logic can be used in the bond market. Interest rates on AAA rated government agency securities are at historic levels relative to U.S. Treasury securities. Panic caused by the volatility in the stock market, the treasury buy-back of its debt and the proposed severing of credit lines with the government agencies, have all led to “blood in the streets” in the agency market and other credit markets. This all bodes well for the long-term investor who has patience. This is in contrast to November 1998, when the combination of the Russian default and the failure of Long Term Capital Management sent interest rates spiraling downward as investors flocked to the safety of treasuries. Once again, this proved to be temporary as interest rates quickly moved back up just a few months later.
All this is not to say that fundamental factors don’t impact markets, but it’s how people react to these factors that creates opportunity.