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How to Survive the Market’s Irrationality: A Guide for Savvy Investors



Why the Market Can Remain Irrational Longer Than You Can Stay Solvent

Have you ever wondered why the market sometimes behaves in ways that seem to defy logic and common sense? Why do some stocks soar to absurd heights, while others plummet to the ground, regardless of their underlying fundamentals? Why do investors flock to buy overvalued assets, while ignoring undervalued ones? Why do bubbles form and burst, leaving behind a trail of financial ruin and misery?

These are some of the questions that perplex many investors, especially those who follow the principles of value investing. Value investing is a strategy that involves buying stocks that are trading below their intrinsic value, based on their earnings, assets, dividends, and growth potential. Value investors believe that the market is not always efficient, and that it often misprices securities due to irrational factors, such as emotions, biases, herd mentality, and speculation. Value investors aim to exploit these market inefficiencies by buying low and selling high, thus earning a profit in the long run.

However, value investing is not without its challenges and risks. One of the most famous quotes attributed to John Maynard Keynes, the influential economist and investor, is: “The market can remain irrational longer than you can stay solvent.” This quote captures the essence of one of the biggest pitfalls of value investing: timing. Even if you are right about the intrinsic value of a stock, you may have to wait a long time before the market recognizes it and adjusts the price accordingly. In the meantime, you may face significant losses, margin calls, opportunity costs, and psychological stress. You may also run out of cash or patience before the market corrects itself.

This is what happened to many value investors during the dot-com bubble of the late 1990s and early 2000s. The dot-com bubble was a period of extreme optimism and speculation in the technology sector, fueled by the emergence of the internet and e-commerce. Many internet companies with little or no earnings, revenues, or profits saw their stock prices skyrocket to astronomical levels, while many established companies with solid fundamentals saw their stock prices stagnate or decline. Many value investors who avoided or shorted the dot-com stocks suffered huge losses, while many momentum investors who followed the trend made huge gains. Some value investors even went bankrupt or gave up on investing altogether.

One of the most prominent examples of a value investor who suffered during the dot-com bubble was Warren Buffett, the legendary chairman and CEO of Berkshire Hathaway. Buffett is widely regarded as one of the most successful investors of all time, with a net worth of over $100 billion as of April 20211. However, during the dot-com bubble, Buffett was widely criticized and ridiculed for his refusal to invest in internet stocks. He famously said: "I don’t understand this technology stuff. We’re not going to play in a game where we don’t know the rules."2 As a result, Berkshire Hathaway’s stock price underperformed the S&P 500 index by more than 20 percentage points in 19993. Many investors questioned Buffett’s competence and relevance in the new economy.

However, Buffett was eventually vindicated when the dot-com bubble burst in 2000-2001. Many internet companies went bankrupt or lost more than 90% of their market value4, while Berkshire Hathaway’s stock price recovered and outperformed the S&P 500 index by more than 40 percentage points in 2000-20013. Buffett proved once again that his value investing philosophy was sound and profitable in the long run.

So, what can we learn from this episode? How can we avoid being caught in a similar situation in the future? Here are some possible takeaways:

  • Don’t invest in something you don’t understand. If you can’t explain what a company does, how it makes money, and what its competitive advantages are, you are better off staying away from it.
  • Don’t follow the crowd blindly. Just because everyone else is buying or selling something doesn’t mean you should too. Do your own research and analysis, and form your own opinions based on facts and logic.
  • Don’t let your emotions cloud your judgment. Fear and greed are powerful forces that can drive you to make irrational decisions. Be aware of your own biases and emotions, and try to overcome them with reason and discipline.
  • Don’t put all your eggs in one basket. Diversify your portfolio across different sectors, industries, geographies, and asset classes. This will reduce your exposure to any single risk factor and increase your chances of survival.
  • Don’t give up on your convictions. If you have done your homework and have a strong belief in your investment thesis, don’t let short-term fluctuations or negative feedback sway you from your course. Stick to your plan and be patient until the market recognizes your value.

The market can remain irrational longer than you can stay solvent. But if you follow these principles, you may be able to avoid being on the wrong side of the market, and reap the rewards of being a rational and prudent investor.

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