Equity markets are cyclical, we guess no one disagrees. Why is that so? If cyclicality causes heartburns, why investors and businessmen don’t make an effort to make it smooth?
Equity markets are cyclical for two reasons.
First, underlying businesses undergo a cycle and second, liquidity (sentiment) in the market fluctuates.
Businesses produce goods and services and work on principles of supply and demand. More supply leads to fall in prices, and more demand leads to rise in prices. When demand is high, a rise in prices leads to increased profits. This incentivizes a company to increase its production. For the very same reason, its competitors too increase the production. This goes on till it reaches oversupply, thereby leading to fall in prices. Now cost of production being same, fall in prices leads to a rapid fall in profits. Why does this happen? When the going is good, a company extrapolates the good times long into the future. This causes cycles in the underlying business.
In second situation, equity markets are cyclical due to flow of money in the economy. When there is surplus of funds, they flow to assets earning the highest returns. Here again, investors tend to extrapolate past returns well into the future, thereby leading to further up-move. This happens till last bull has bought the securities. After that, it starts falling down. On its way down, lower returns are extrapolated into the future, and more liquidity is pulled out. This causes cycle in equity markets.
Stronger the human fallacies, more is the volatility!
It’s not hard to believe the above actions. We see human fallacies from day to day—Greed, fear, recency bias, extrapolation of current situations, herd behaviour and not paying heed to history and base rates. Stronger the fallacies, more is the volatility!
We can’t escape the ill consequences of human fallacies. We ought to learn to dodge it for our personal benefit. Acting alone is not an easy job. As humans, we think and act in herd. That has helped humans to survive & evolve, but it’s not helping them prosper. Very few have managed to prosper at the expense of others. Likewise for your prosperity, you have cut yourself from the crowd; and think and act differently.
Don’t let cycles influence you.
Since you know markets tend to be cyclical, don’t let cycles influence you. Unless you behave in counter-cyclical manner, you won’t emerge superior. Hence, you must buy businesses those are undergoing down-cycle and sell businesses in their upcycle. Likewise, we buy more when markets are correcting, and sell when markets are rising. We have done very well when markets fell, but we did just fine when markets risen. We have always bought good businesses that were rejected due to temporary pains, and we sold the ones which were the most sought after. This helps us prosper over the market.
It is simple, but it is not easy! It requires constant reminder to mind, re-visiting this philosophy and courage to see others getting rich in the short term. If your performance is very similar to market performance, you are not behaving in counter-cyclical manner.
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