Greed, Fear and Uncertainties

My investment idol, Peter Lynch, talks about "The cocktail theory" and 4 stages to understand the market sentiment. I always believed investment is just understanding those 4 stages and act accordingly. I simplified my investment rationale based on "The cocktail theory" as follows

1. Greed
2. Fear
3. Uncertainties.

The art part is to identify the actual stage and exercise some prudence depending on the stage to be successful.

Greed:

In the words of Buffett "Be fearful when others are greedy". At the same time, In Keynes words, "Market can stay irrational longer than you can remain solvent". So the key aspect at these level is those three magical words Margin of safety. Place a greater emphasis on the margin of safety both for individual stocks or mutual funds.

Feb 2015 could be one instance when the greed took over the markets and went up way ahead of the fundamentals.

Fear: 

The second part of Buffett's quote on fear says "Be greedy when others are fearful". My mind goes back almost 11 months ago when Nifty levels dropped to almost 6800 and most of the global indices were down 15%. I felt It was time to be greedy and those who entered around those levels would be sitting on decent returns in spite of the recent sell off in emerging markets post the US elections.

Uncertainties:

This, I believe, is the most difficult stage to understand and also the zone where market stays much longer than Greed and Fear. The good thing is the entry and exit opportunities are much more than the other two stages. I call this uncertain because of the lack of visibility going forward and the influential factors which could have a significant impact on the overall markets. It's extremely important to understand the risk-reward ratio while working out a strategy during this stage. Some uncertainties offers huge risk to reward ratio and others, low or negligible.

Oct 2016 : Markets have been rallying almost one way from the Feb lows and there was a huge uncertainty going into the US election. I felt the risk to reward was high, considering the huge rally from Feb including Fixed Income Funds. So the suggestion was to be prudent, book some profits and stay on the sidelines till some clarity emerges. Post the elections, most of the markets, including bonds, had a decent correction except for the US markets.

22nd Nov 2016 : The day after the inauguration of Mr. Donald Trump, as the US president, I feel we are in a similar situation, But, I am a bit baffled by the optimism in markets with most emerging markets are up at least 5% from their recent lows and the US markets very close to its all time highs. The risk-reward is clearly unfavourable to handle any negative surprises. I also believe some of the job creation and protectionist measures would come at a price and would most likely hit the bottom-line of the US companies.

How do you prepare for the unexpected – it’s unexpected? 

If the first 24 hours are anything to go by, there are many known unknown in terms of policy changes, job creations, H1B policies or tax proposals. There are unknown unknowns like the effect and scale of the anti-establishment protests. So my suggestion is to allocate 30% into equity and set aside 70% in Fixed income/money market funds, wait till some certainty emerges over the next few months and avoid getting caught in the middle of a deep correction. My biggest fear is what if Dow has already scaled its high for the next few years?  It's time to place importance that three magical words "Margin of Safety".

Good luck and happy investing.