The Buffett principle and Dalal Street

by Vivek Kaul & Nikhil Lohade / DNA Money

Like a teenage love affair stocks soar without wings and crash without taking off — Raju Samal in his book, Many Moods of Mumbai
Sandipan Raina had to make a speech on the investment philosophy of Warren Buffett and its relevance during the present state of the Indian stock market.
He had been trying to concentrate on writing the speech, but his thoughts kept going back to last evening. He was in a book shop and while paying for a Ruskin Bond title he had bought, he had run into a woman, who smiled and said, “Not many people read Ruskin Bond these days”.
He smiled back. But before he could muster enough courage to take the conversation forward, she turned around and disappeared.
How would he find her? All he knew about her was that she had beautiful eyes and that she loved Ruskin Bond. With all these thoughts in his mind, Raina started speaking.
“I am a regular reader of the annual letter Warren Buffett sends out to the shareholders of Berkshire Hathaway, whose chairman he is. He regularly elaborates on his investment philosophy through these letters,” Raina started on a confident note.
“In the letter to shareholders in 2005, he said, ‘Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac’s talents didn’t extend to investing: He lost a bundle in the South Sea Bubble, explaining later, I can calculate the movement of the stars, but not the madness of men.’
“If he had not been traumatised by this loss, Sir Isaac might well have discovered the Fourth Law of Motion: ‘For investors as a whole, returns decrease as motion increases.’
This, ladies and gentlemen, is a basic law investors forget as markets keep going up. During a bull run, investors tend to look at the returns in the recent past and assume that the future returns will be identical. They mistake probability for certainty and pump in more money into the stock market. And when the market falls, there is great pain”, continued Raina.
“In the letter to shareholders in 2000, Buffett had said, ‘The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money.
After a heady experience of that kind, normally sensible people drift into behaviour akin to that of Cinderella at the ball. They know that overstaying the festivities- that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future will eventually bring on pumpkins and mice.
But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands’.
“Well, investors are no different from other human beings. The lure of quick wealth is difficult to resist. During a bull run, stock markets offer astonishing returns in a short period of time as compared to other investments. This helps in attracting more money into the stock market and so the markets keep going up,” said Raina. “But is this really good for potential investors?” asked Raina.
“Well, Buffett had already provided the answer to this question, in the letter he sent to shareholders in 1997. ‘A short quiz: If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves.
“But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the “hamburgers” they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices,” said Raina and concluded his speech.
As he was leaving the venue, there was a tap on his shoulder. He turned around to se, the same woman standing there and smiling as usual. In this big bad city, he had run into her again. Life, as they say, is stranger than fiction.
(The example is hypothetical)
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