“Periodic outbreaks of those two super-contagious diseases, fear and greed, will forever occur in the investment community. The timing of these epidemics will be unpredictable. And the market aberrations produced by them will be equally unpredictable, both as to duration and degree. Therefore, we never try to anticipate the arrival or departure of either disease. Our goal is more modest: we simply attempt to be fearful when others are greedy and to be greedy when others are fearful.” – Warren Buffett
When I first read this quote many years ago, it resonated with me. I could immediately see the wisdom in Buffett’s thinking, and it was certainly memorable. Quoting it made me feel smart but I really had no idea how to use it to make money. I understood the philosophy behind it but putting it into practice proved much more difficult.
After many years of study, a graduate degree, and reading dozens of books on personal finance and investing I still consider this one of the smartest and most memorable things ever said about investing. Over the years, through study and practical experience, I have learned several ways the average investor can make money using the contrarian investment philosophy espoused by Buffett. I would like to share them with you.
As Buffett indicated, you don’t need to time the market to be successful. It is not important to know in advance when people will become fearful or greedy, only to note when it’s happening and react accordingly. These methods also don’t require you to pick winning stocks like Buffett does, which is a skill that is difficult to duplicate. All of the methods I describe can be implemented using low-cost index funds, which is what I recommend.
I believe behavior is more important than knowledge in investing, and giving up on stock picking and market timing, which almost no one can do successfully, allows you to focus all of your attention on controlling your behavior. So, without further delay, here they are:
5 Simple Ways to Make Money Being Fearful When Others are Greedy and Greedy When Others are Fearful:
- Don’t just do something, stand there
- Tilt to Value
- Bet Big During a Crisis
Don’t Just Do Something, Stand There
Buffett himself offers the first clue on how to be a successful contrarian investor. Recognizing the difficulty of implementing his philosophy, Buffett states, “You know, I always say you should get greedy when others are fearful and fearful when others are greedy. But that’s too much to expect. Of course, you shouldn’t get greedy when others get greedy and fearful when others get fearful. At a minimum try and stay away from that.”
In other words, when others are acting irrationally, don’t just do something, stand there. Being a successful investor is often as simple as that. When everyone else is behaving badly, doing nothing makes you look like a genius in comparison.
There is a commercial currently playing on TV that drives me crazy. It is a commercial for Rosland Capital advocating investing in gold. The commercial features actor William Devane, and speaking of the market crash of 2008 he states, “The government bailed out the banks, but who bailed us out. I didn’t get any money. Did anyone replace what you lost in your retirement? Lesson learned!”
Actually, I think he learned the wrong lesson. Every time I hear this commercial I want to yell at the TV, “Yes, as a matter of fact someone did replace the money I lost, and added extra on top of it.” The market took care of that all by itself.
In the market crash of late 2008 and early 2009 my 401(k) lost over 50%. However, by the end of 2009 it had recovered all losses and posted about a 6% return for the period, and by the end of 2010 I had a gain of 11% since the market crash.
What did I do to obtain these amazing results? Absolutely nothing; or at least nothing new. I simply refused to be fearful when everyone else was panicking. I stuck to my long-term investment plan which allowed me to buy stocks when they were on sale. The result was a complete and fairly quick recovery, followed by gains leading to new highs.
I know many people that bailed on stocks during the crash. This turned what should have been a temporary setback into a permanent loss. Many of these people are still not back in the market, and may never invest in stocks again, compounding their loss further.
When the next crisis comes – and it will come – remember Buffett’s advice. Refuse to be fearful or greedy when everyone else is. Don’t just do something, stand there!
Everyone should have a long-term investment plan that describes how you will allocate your assets between stocks and bonds, and between different types of stocks. If you don’t already have such a plan, your first step is to develop one. For example you might decide to put 20% of your money in bonds, 30% in foreign stocks, and 50% in US Stocks.
Over time these assets will perform differently from each other, and your allocations will drift away from your pre-determined targets. For example, in 2014 US stocks vastly outperformed foreign stocks. Because of this, at the end of 2014 you might find that foreign stocks now make up only 27% of your portfolio and US stocks have risen to 53%.
Your first reaction will be to dump the foreign stocks and invest the money in more US stocks. This would break Buffett’s rule as you would be fearful along with everyone else with respect to foreign stocks, and greedy along with everyone else with respect to US stocks.
The correct move would be to sell enough US stocks and buy enough foreign stocks to restore your portfolio back to the 30/50 ratio in your plan. This is called rebalancing your portfolio. In the words of David F. Swensen, rebalancing forces you to “sell what’s hot and buy what’s not.”
Rebalancing is generally thought to give you two advantages. Over time rebalancing:
- Lowers risk, and
- Raises returns
While these two advantages are important I think rebalancing has a third often overlooked advantage that is even more important. Rebalancing gives you a regular chance to exercise your contrarian investing muscles. When you first start rebalancing it will be difficult to “sell what’s hot and buy what’s not” but with practice, just as with lifting a certain amount of weight, it will become easier.
Your regular contrarian workout will pay off during the next bear market, when sticking to your plan will become very difficult. As Swensen states, “Under normal circumstances, rebalancing asks for modest degrees of fortitude. When markets make extreme moves, rebalancing requires substantial amounts of courage.” Regular rebalancing will help you develop the needed strength and courage to stick to your plan no matter what the markets throw at you.
Overbalancing is rebalancing on steroids. When you rebalance you sell enough of what’s hot and buy enough of what’s not to restore your portfolio to your target allocations. In overbalancing you do this…and then you go a little further.
In the example above you might buy enough foreign stocks and sell enough US stocks to change your allocations from 30/50 to 32/48. This allows you to profit even more from the fear and greed of others.
I learned about overbalancing from William Bernstein in his excellent book The Intelligent Asset Allocator: How to build Your Portfolio to Maximize Return and Minimize Risk. After teaching the concept Bernstein adds some warnings that are worth repeating:
“Don’t try this one at home, unless you have rebalanced successfully through at least a few market cycles. If you do get to that point, remember, increase your allocation of an asset only after it has gotten measurably cheaper…. Never increase your allocation to an asset because of economic or political events or because you have heard an analyst make a convincing case for doing so. The same goes for decreasing your allocation in a given area: Do so only because its valuations have gotten much higher after a major run-up.”
Like Buffett said, don’t try to anticipate when fear and greed will come, simply react to them after the fact. Overbalancing is another tool you can use to do this.
Tilt to Value
In the investment world the cool, happening, industry-leading, hear-about-in-the-news companies are known as growth companies. These are the popular kids in school that everyone wants to be associated with. The result is that the stocks of these companies are expensive to buy. Investing in these companies amounts to being greedy when everyone else is greedy.
Companies that are struggling along are known as value companies. Their performance has been sub-par and expectations for the future aren’t much better. The stocks of these companies are cheap because no one wants to be associated with them. Investing in these companies amounts to being greedy when everyone else is fearful, which is where we want to be.
Eugene Fama, who won the Nobel Prize in Economics in 2013, and Kenneth R. French have shown that over long periods of time investing in value companies is more profitable than investing in growth companies. William Bernstein explained why this is the case:
“Bad companies are cheap; it is quite possible that management will turn the company around and make them back into ‘good’ companies. Further, even if a bad company’s performance worsens, it will not surprise the investment world; the price will probably not drop all that much. On the other hand, good companies are expensive; they are expected to grow to the sky. When, as inevitably happens, they stop growing to the sky, they are taken out and shot by the market.”
There are several ways to classify growth and value companies which are beyond the scope of this discussion. Fortunately, this knowledge is not needed as there are many value index funds that have already done this for you and are available for purchase.
Regular index funds invest in both growth and value companies, but are tilted towards growth since these companies tend to be larger and more valuable. In order to be a contrarian you need to own enough of one or more value funds to tilt your portfolio towards value. How much you tilt towards value is a personal decision but doing so in some degree is another great way to profit off of the irrational fear and greed of the market.
Bet Big in a Crisis
John Templeton came from humble beginnings in rural Tennessee. In 1939 Templeton was a young man of little means trying to make his way in the world. The US had still not recovered from The Great Depression and World War II had just started with the German invasion of Poland.
Things could not have looked worse and just about everyone in the world was fearful. Despair was everywhere and hope was a rare commodity. Templeton, thinking that things could only get better, figured this was a great time to make a big move.
He had been saving 50% of his earnings and in doing so had managed to accumulate $10,000. This was long before the days of index funds, so Templeton simply created a crude but effective value fund of his own. He purchased 100 shares of every company trading under $1 per share on the New York Stock Exchange.
Things eventually did improve, as they always seem to do after a crisis, and in the post-war boom Templeton’s investment paid off in a big way. He eventually launched his own mutual fund company and became one of the richest and most successful investors ever. He was also one of the most generous philanthropists in history, giving away over $1 billion to charities, and was Knighted Sir John Templeton for his work in philanthropy.
All of this was made possible because Templeton refused to be fearful when everyone else was. When the whole world saw despair as the only option Templeton managed to muster a degree of hope for a better future, and to put his limited resources to work to make it happen.
Templeton is not alone in this regard. Many fortunes, great and small, have started with a big bet in a time of crisis. In fact, the best time to be greedy is when just about everyone else is fearful.
During your investment life, if history is a guide, there will be three to four financial meltdowns. There have been two recently, in 1999-2000 and 2008-2009. Hopefully none will be as bad as the Great Depression but all of them will present you the opportunity to make a big bet and earn a big reward when things inevitably turn around. Betting big in a time of crisis is another useful tool to keep in your contrarian toolbox.
There you have it. Five simple ways to make money off the irrational fear and greed of the market.
First, learn to resist the urge to follow the crowd. When others are behaving irrationally, don’t just do something, stand there!
Second, decrease risk, increase return, and develop your contrarian muscles by selling what’s hot and buying what’s not through regular rebalancing.
Third, give your contrarian muscles a real workout by overbalancing.
Fourth, tilt your portfolio towards unpopular value companies by investing in one or more value index funds.
Fifth, make a big bet during a time of crisis.
These strategies are simple, but not easy. None of them take a lot of knowledge to implement, but they do require varying degrees of courage and resolve. Like regular workouts to stay in shape the only way to develop this courage is through regular exercise of your contrarian muscles. It’s not easy being fearful when others are greedy, and greedy when others are fearful, but the rewards are well worth the effort.