As we live in the Age of the Internet, we have to contend with random investors (and some gurus) who quote famous investment icons to prove a particular point to a reader. One saying that gets repeated again and again in this COVID virus season is the saying by Warren Buffet that we should “be fearful when others are greedy and be greedy when others are fearful.” Warren Buffett is the billionaire investor that many gurus would love to borrow authority.
In my opinion, quoting famous investors to make a point does not add value to a retail investor if the context of the original saying is unknown. Also, I expect that most retail investors will not share the same personal circumstances as Warren Buffett. Case in point, most retail investors do not own an insurance company like GEICO that provides enough float equivalent to billions of dollars of interest-free margin account loans.
This article provides a better approach to think about quotes when faced with them in the future.
Here is what I would do to bring the “be fearful” quote by Warren Buffett to the local investing masses.
#1 – Turn the subjective terms in the quotation into an objective one that is measurable.
If we examine the quote, the first word that should jump right at you is “fearful”, and as it turns out, there is a way to measure the amount of fear in the markets at any moment. The CBOE Volatility Index or the VIX index uses options prices to determine its value. When options prices spike, so does the VIX index. One useful application of the VIX index is that it measures the amount of fear existing in markets at any point in time.
#2 – Form a hypothesis by asking what holds if the quotation is correct.
If you sell when others are greedy and buy when others are fearful, what does it mean, and how do you measure the consequences? One way of doing this is to consider what happens when you buy a stock when there is a lot of fear in the markets and sell when the fear subsides.
Therefore, if Buffett is right, stocks should drop when there is a lot of fear and recover when the fear ends, allowing investors to earn a profit. i.e. If your hypothesis is right, then the stock should go up when VIX goes down, and the stock should go down when VIX goes up. Framing it mathematically, whatever you buy should have a negative correlation with the VIX index.
#3 – Test the hypothesis using real market data
With a reasonable hypothesis, it is time to crunch the numbers. With my Python programming skills, I can plot stock movements relative to an imaginary portfolio invested in the VIX index.
We look at the period during the COVID-19 crisis where the VIX traces a very dramatic inverse V-shaped pattern from 14 February 2020 to 1 June 2020. The following charts compare portfolios invested in both indices during that time.
This first plot compares the performance of the benchmark STI index with the VIX. Because the volatility of the VIX is very high compared to the STI, we can only observe a very subtle kink in STI performance when the VIX peaks.
The most useful indicator in this regard is the -0.2181 correlation between the VIX and the STI aas highlighted on the chart. Correlation, a number between -1 and 1, measures the extent to which stock counters move together. A positive number means that when one counter moves up, the other does the same. A negative correlation thus shows that the STI has a tendency to drop when the VIX rises, allowing the opportunistic retail investor to earn some profits when there is “fear” in the markets.
So generally speaking, our quick experiment vindicates the Warren Buffett quote to “be fearful when others are greedy and be greedy when others are fearful.”
#4 – Find instances where the quote does not apply
As finance is a very unpredictable subject, and we should not stop after showing that a quote generally holds true. We can explore whether the hypothesis holds with other investments.
We can make a similar comparison with local REITs so we can repurpose the code to compare Lion Phllip S-REITS ETF with the VIX index. Predictably the correlation remains negative, but it is much smaller at -0.18 compared to -0.21 for the STI, so buying REITs when the VIX spikes may be less effective than investing in blue-chip stocks.
We continue press on and compare the VIX with the ABF Bond ETF. This time we find that correlation between bonds and the VIX is positive at 0.32. This is a totally different kind of relationship: local government bonds go up when the VIX spikes, and bonds have a tendency to drop when the VIX declines.
#5 – Determine how to play the markets with your new insight.
Designing an action plan is the hardest part of investing. Based on what we have tested so far, elements in your investment plan should include buying stocks when VIX is rising/high and buying more bonds when the VIX is falling/low.
In practice, this is difficult because of the underlying market panic when the VIX begins to spike. The first few trading days after making your purchase, you may even end up catching a falling knife.
In summary, one of the most annoying things retail investors have to endure on the Internet are gurus parroting the sayings of top investors on the web in a shallow attempt to borrow the authority from a more successful investor. We can take an enlightened approach and verify the extent to how much these sayings hold.
I challenge readers to perform a similar exercise on another favourite quote from Warren Buffett, “price is what you pay. Value is what you get.”
