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I want to tell you about how we think about investing. No one can offer a rule that will always work. The best we can do is offer a way of thinking that works most of the time. Our job as investors is to do the job as best we can. If we do mediocre work, we are not adding any value. Our advantage is that we generate good income while controlling risks.
A great investment. That's the whole point. Everything an investor does falls into one of two categories. Not everyone organized the process this way. That's how I think of it. Number one, asset selection. Owning more things that work well and fewer things that work poorly. Number two, cyclic positioning.
Have more investments, invest more aggressively when times are good, and invest less, be more defensive when times are bad. In other words, oscillation between offense and defense. The choice at any given time between offense and defense is the most important choice an investor makes. The question is not whether it is American stocks versus foreign stocks, equities versus bonds, small cap versus large cap, value versus growth.
The most important thing is whether to be aggressive or defensive at a given moment in time. If you can do that right, everything else will fall into place. And if you do it wrong, the rest won't help. Offense versus defense. When you look at bull markets, and I've been involved in six, seven, eight major bull markets in my 50 years in this business, I think the things that are recurring are: high levels of optimism, low levels of risk aversion, and an excess of capital available for investment.
These three things, when you think about it, make up a pretty good recipe for a bull market, and in their absence, it's hard to imagine how we would have a bull market. So, optimism, risk aversion, and availability of capital . Asset prices are a function of two things. Fundamentals, the reality of the company, real estate, stocks, whatever it may be.
And then how these fundamental indicators are perceived through the filter of emotions or psychology. What causes price fluctuations to increase? What causes asset prices to overstate their fundamentals and become unstable? And the answer is optimism. I summarize this as optimism. There are many factors, but it's clear that when, uh, people are positive about the future, when they believe in positive stories, when they expect more and more from companies, uh, those are the times when asset prices rise relative to intrinsic value, which leads to higher prices for people who own the asset, but makes the price volatile.
In hot times, when bidding is brisk, sometimes the price gets too high and the winner of that auction actually loses because he or she paid too much and accepted too much risk for the reward of, er, too little return. We need to know when that is the case. I often write about what I call the seven worst words in the world.
Too much money chasing too few deals. In other words, excessive availability of capital. And when there is too much money in the market and people are too eager to use it, trading becomes too high and profitability deteriorates, risk increases, and the structure of what is being sold weakens. So let's talk about how these things interact with each other and what a typical cycle looks like.
So, let's say we're at a low level. Maybe we just went through a crash, crisis, or correction, and asset prices are low. The economy is showing poor results. Most people suffer from previous losses. What happens in the end ? Yes. Eventually, improvement comes. The economy is starting to strengthen. Companies start reporting better earnings, and once the trend gets big enough, the media turns to investing, mentioning mostly favorable events.
If this goes on long enough, eventually investor expectations rise , optimism rises, asset prices rise. This causes people who held assets to celebrate and buy more. Eventually, people who didn't hold the assets capitulate and finally give up and buy themselves. Everyone is a buyer. Not many people are salespeople because everyone feels favorable.
This means that asset prices rise even more , which brings more confidence to the markets and leads to the disappearance of risk aversion. At this stage of the market, people usually say, "I like to take risks." Risk is my friend. The more you risk, the more money you make. Let's go ahead. Eventually, the economy starts to perform worse .
Corporate profits are not surprising, they are disappointing. Eventually, the media picks up on this and starts talking about negative events rather than positive ones. What is happening? Investor expectations are weakening . Psychology becomes more depressed. Now prices are falling. People bear losses, not profits.
Those who held the shares are being persecuted and they are exiting the market. Maybe they are selling. Those who didn't hold on are celebrating. They pat themselves on the back, but of course they don't rush into the market. Now there is a growing risk aversion , and people say that risk is just another way to lose money.
I will never touch this again. And this is what's happening below. People who haven't been, who have n't been in the market, are definitely rushing out and buying. This is the time when the countercyclical, unemotional investor should become aggressive. It's not easy. Everyone does the opposite. Everyone buys at the top because it feels good.
Everyone is selling at the bottom because they are depressed. This is what creates peaks and troughs. Your task, as far as you can do it, is to do the opposite. But you are subject to the same environmental influences as everyone else. How can you resist these things? Well, first, you have to understand the role of emotions.
You should understand that fundamentals don't fluctuate that much. Emotions and psychology fluctuate much more. You must understand the importance of being unemotional. It's not easy. If you are as emotional as a typical investor, you will do the same things as a typical investor. That is, you will buy at the top, sell at the bottom.
And, of course, you won't outdo others. You should strive to achieve better results. As? Be unemotional by hiring unemotional investment managers without interfering in the process. But we always did it with trepidation. We never said we were buying, and we are 100% sure that is correct. We said we were buying, and we think we were right.
We buy a little. Maybe it will get even cheaper. Maybe we buy more. By the way, one of the big mistakes you can make is waiting for the bottom. Many people say, “I’m not going to buy. I'm not going to try to catch a falling knife. Instead, I will wait for the dust to settle and the uncertainty to disappear.” And you know what?
When the uncertainty disappears and the knife stops falling, the bargains will disappear. You get good deals during a downturn when everyone else wants out and they want your help to let them out as prices cascade downward. Take a look at this diagram. The US money supply is growing at one of the fastest rates in the last 5 years.
When liquidity increases, more capital begins to seek investment opportunities, often increasing demand for financial assets. This is exactly what legendary investor Mark explained. As excess cash flows through the economy, investor optimism grows, fear gradually dissipates, and markets find it easier to accept higher valuations.
More assets chasing money could push stock prices higher before fundamentals catch up. Understanding this relationship between liquidity, investor psychology, and valuations can help you make better investment decisions throughout each market cycle.
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