Home / Money / Personal Finance /  Scientific investing protects, creates wealth beyond the bull market rush

We find that whole communities suddenly fix their minds upon one object and go mad in its pursuit; that millions of people become simultaneously impressed with one delusion, and run after it, till their attention is caught by some new folly more captivating than the first."

—Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds

The recent 1+ year bull market and IPO frenzy have delivered high returns. Many people might have triple-digit returns from the bottom of the market, which is not surprising given that Nifty 50, Sensex, S&P 500 and Nasdaq all have delivered close to 100% returns from 20 March 2020.

No one can argue with the high returns an investor has made. However, if this is not backed by a true investment philosophy, the returns are likely to prove illusory and eventually that money is likely to be lost over the full market cycle.

Millions of investors—not only first-timers, but also professionals or experienced ones—have learnt, wrongly, that there is an easy way to make money. In the middle of a bull market is the perfect moment to understand and remind ourselves of the correct way to make money from equity markets and caution ourselves of the wrong ways and their illusory returns which cannot sustain for the full cycle but are likely to drain from the portfolio when the bear comes eventually.

Let us revisit the science of investing and the first principles governing it. At the heart of investing is the concept of intrinsic value. Any asset should have clearly visible cash flows in the future. And these cash flows should not be from other “investors". These should be from users of that asset to satisfy their needs or demands.

At the most basic level, an investor invests in or buys an asset to get the cash flows from them. If an investor is happy with the expected cash flows, he or she can invest even in an unlisted asset.

If the asset is listed and there is a market price, the market price is one more way for the investor to get their returns. If the market price is significantly higher than the intrinsic value, it is beneficial to sell the asset in the market and lock-in the returns which are higher than the estimated cash flows.

What confuses many investors is the quick upward movements which happen during bull markets. Many “investors" learn wrong lessons either from their own experience or seeing others making huge short-term gains.

This experience is very difficult to unlearn. Even after they lose money, they keep searching for the “method" or “system" which will help them predict what can go up higher and quicker.

Contrast this with someone who learns from the first principles. Such an investor, the scientific investor, would know about cash flows, understands what assets, discount rates, intrinsic value, expected returns and market price are.

They would understand when speculative gains are being made in the markets and would not get confused by quick and temporary gains or eventually quick and temporary losses. This is called the scientific investing approach. They would learn to buy when stocks are being sold by Mr Market at a significant discount to intrinsic value—with a large margin of safety—and sell when the stocks are being demanded by Mr Market at intrinsic value or a premium to intrinsic value.

This done over and over multiple times and multiple market cycles would result in a significant alpha generation over and above the market returns. The alpha would be equal to the margin of safety.

As the cult of momentum, or buy whatever goes up, is reinforced during the bull market, the participants go crazy. Any statement or philosophy which doesn’t support this perspective is ignored or ridiculed and all “strategies" which promise to deliver extraordinary returns in short time-frames look like the answer.

It has been like this in every bull market for the past 500 years and is likely to remain so in the future. But a minority of market participants understand the scientific investing way based on the first principles of investing. The stock market becomes a giant machine to transfer the wealth of the cult of momentum to scientific investors. You have to choose to be on the right side of wealth creation.

Vikas V. Gupta is chief executive officer and chief investment strategist, OmniScience Capital.

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