Like clownfishes, while navigating their way towards home, lose the ability to sense vital smells in more acidic waters, investors lose their sense of smelling trouble during bull markets.
If you have kids, or even if you don’t, I am sure you must have watched Disney’s animated movie Finding Nemo. It tells the story of the overprotective clownfish named Marlin who, along with a regal blue tang named Dory, searches for his abducted son Nemo all the way to Sydney Harbour. Along the way, Marlin learns to take risks and comes to terms with Nemo taking care of himself.
Marlin had big reasons to worry when Nemo was abducted. This is because clownfishes live their entire adult lives nestled in the protective arms of a single sea anemone (group of water-dwelling, predatory animals named after a terrestrial flower) on a coral reef.
Between birth and adulthood, however, the fishes have to complete a treacherous journey. After hatching, a larva – a tiny, partially formed version of an adult fish – swims out of the reef to the open sea to finish developing, presumably away from predators.
After maturing for 11 to 14 days, the young one is ready to swim back to the reef and select an anemone to call home. But as it swims close, it must cross a “wall of mouths” – all kinds of creatures that lurk around the reef ready to gobble up the tiny fishes.
To successfully navigate these dangerous waters a clownfish needs to recognize the smells of the predators and avoid their grasp.
The sense of smell is really chemistry in action: detecting, understanding and responding to molecules in the water. Even a small shift on ocean chemistry could throw off this delicate survival mechanisms. In fact, it already seems to be happening. The waters are becoming more acidic, as the oceans absorb more carbon dioxide from the atmosphere, thanks to us humans burning more fossil fuels.
As scientists have uncovered, clownfish larvae lose the ability to sense vital smells in more acidic waters, probably owing to the damage caused to their sense of smell. In fact, they can’t distinguish between their own parents and other fish, and they become attracted to substances they previously avoided.
Anyways, if you are still reading this, you must be wondering why I am discussing clownfishes, their sense of smell, and rising acidity levels in oceans. How does this relate to investing or how individuals behave when it comes to their investments?
Before we discuss that, here’s what the famous American astronomer Edwin Hubble is supposed to have said –
Equipped with his five senses, man explores the universe around him and calls it science.
So, investing has five senses of its own –
1. Sight – Seeing the business and how it works, analyzing financial statements etc.
2. Hear – Hearing the sounds that the financial statements make, after you’ve thoroughly analyzed them. Some sounds are melodious (good balance sheets, cash flows, etc.), while many are unpleasant (debt-ridden balance sheets, negative cash flows, declining profits, etc.). Also, listening to what your mind and the biases in your brain are telling you.
3. Touch – Touching upon other key points of an investment, like key risks a business faces, liquidity, promoter shareholding, insider trading etc.
4. Smell – Smelling ethics, or lack of it, in the way business is managed.
5. Taste – Invest in a business that looks and hears.
Of course, there is a sixth sense. i.e., intuition or gut feeling that often helps us a lot in our decision-making process, let’s keep that aside as topic for a future post.
With respect to the above five senses, many investors have the tendency to concentrate heavily on just one or two of these and disregard the rest. And one of the senses that is often disregarded is that of … smell.
Smell Your Way to Investment Success
Do you smell it? That smell? A kind of smelly smell, a smelly smell that smells, smelly. ~ SpongeBob SquarePants
We don’t think of ourselves as being particularly good smellers, especially compared with other animals. But research shows that smells can have a powerful subconscious influence on human thoughts and behavior.
People who can no longer smell — following an accident or illness — report a strong sense of loss, with impacts on their lives they could never have imagined. Perhaps we don’t rank smell very highly among our senses because it’s hard to appreciate what it does for us — until it’s gone.
Of course, when it comes to our investments, we cannot smell our stocks (at least not anymore when they are not in paper, but demat, form) in the literal sense of the word. But having a sense of smell plays a critical role in our survival and prosperity as investors.
Let’s go back to the story of clownfishes and how their recognition of the smells of predators helps them navigate dangerous waters and return home safely.
When it comes to investing, this sense works in helping you recognize the smells of predatory managements –
• Those that lack integrity (damn their good business skills).
• Where what they say and what they do does not match.
• When what they promise looks too good to be true.
• Those that are over-risking their present while promising a bright future.
• Those that are flamboyant and are often seen talking up their stocks prices than managing their business affairs.
Management is one aspect of business analysis that cannot be gauged perfectly using numbers. So even when you can ‘see’ the management, and ‘hear’ them, it’s often your sense of ‘smell’ that can help you differentiate between the protectors and predators of your interests in the business.
And then, not just the management, even the business requires you to use your sense of smell –
• Is the rapid growth in sales during the last quarter of the financial year for real? Or can you smell dumping of inventories to the dealers?
• Is the rapid growth in advances, faster than compared to the industry, suggests the robustness of the bank? Or can you smell rash lending and thus a future increase in NPAs?
• Is the sudden increase in dividend a sign of management wanting to share more profits with shareholders? Or can you smell a Ponzi scheme here where the management is borrowing from someone else to pay to someone else?
• Does the rapid growth in profit looks too good to be true? Or can you smell under-reporting of expenses (evading taxes, capitalizing interest costs, etc.)
• Can this new age, fast growing business really be a good long-term bet? Or can you smell a hot potato here?
Of course, your ability to smell trouble will lead you to use your other senses, like sight, because you would want to see deeper into the financial statements. But this would only happen – that you explore a business deeper than act on first impressions – when you give your sense of smell a chance to help you.
But Then Comes the Bull Market
In the case of clownfishes, like I mentioned above, the rising acidity in sea water disrupts their ability to smell and differentiate between their protectors and predators.
When it comes to investing, bull markets signify such rise in acidity levels in the investment environment that wreaks havoc on all our senses, including that of smelling for dangers in businesses and managements.
As the emotions of greed and envy grab hold of investor sentiments, it creates noise and hampers a common investor’s ability to smell the risk. The beast called Bull Market feasts primarily on these two human emotions – greed and envy. ̄As these two emotions intensify, everyone in the market – investors, brokers, financial institutions, promoters, management – gets infected with this contagious disease called ‘easy money’.
Warren Buffett said, “Nothing sedates rationality like large doses of effortless money.” The rising wave of bull market raises all the boats but only when the tide goes out it’s revealed who was swimming naked, quips Buffett.
Modern technology and the ease of access of information has further fueled this effect. Fortunately, it’s become easy, for the vigilant investor, to sense the onset of bull market. When you start receiving unsolicited stock advice on WhatsApp and social media feeds, you know that the metaphorical carbon dioxide levels are rising around you. That’s how the bull market smells.
I have been investing my own money for the past many years but not many of my friends ever approached me with questions about investing. These days quite a few of them want to know which stocks I am buying. I smell something bad.
When my father, who has not invested much in the stock market, tells me that the market has hit a new high, I smell something bad.
Bull market is characterized by intense hyperactivity in the financial world. Brokers get busy soliciting new customers, financial institutions suddenly wake up and start pursuing new investors, AMCs get busy launching new funds, financial media starts buzzing with interviews of fresh faces and stock tips abound from obscure stock market millionaires. It doesn’t end there. There are other activities that add fuel to the fire. As the stocks become expensive CEOs get restless to do more mergers and acquisitions, investment bankers get busy with their next set of innovative (and eventually destructive) financial instruments, and promoters start salivating at the thought of raising unneeded (but highly desired) money through their overhyped-oversubscribed IPOs.
One metric we track at Safal Niveshak is the demand for our value investing workshops. When there is unusually high participation in our workshops and lot of people start mailing us to conduct more workshops in their cities, we smell something bad.
Another tell-tale sign of acidity in the market is high expectations. Everyone starts expecting to double and triple their money in one year. A fresh breed of advisors start touting their investment record. It’s funny when a new investment advisor tells you that he has generated a CAGR of 60 percent in last 6 months. No sane investor would ever talk about 6-monthly CAGR!
In stock market, the increasing levels of acidity are perfectly correlated with shrinking time horizons. Morgan Housel, a brilliant investment journalist, wrote on his blog – “Bubbles aren’t so much about valuations rising. That’s just a symptom of something else: Time horizons shrinking.” So true!
In high adrenalin bull market environment, it’s not easy to find out who is the predator and who’s the protector. The predator in such environment would try to bring your focus towards FOMO – fear of missing out. The protector will draw your attention towards FOBU – the fear of blowing up. Unfortunately, when Mr. Market is roaring with irrational optimism, FOMO sells better and the voice of FOBU gets drowned in the cacophony produced by demons of greed and envy.
Gresham’s law dictates that bad money drives out the good money from the marketplace. It’s true for stock market too. As the bad emotions of greed and envy spread, they drive out the good virtues i.e., patience and rationality. The good investment practices are driven out by aggressive and risky investment strategies. Good companies get pushed down in the stack and the bad ones become the market favourites. The voice of risk-averse and conservative investors gets tuned out and the so called flamboyant market makers rule the roost.
No one, including yours truly, can predict the market inflexion points. No one knows how long will a bull market last and how long the following bear market would be. Even if I have all the reasons to believe that markets are heating up, there’s no guarantee that the bubble will burst soon. Sir John Maynard Keynes instructed, “Markets can remain irrational longer than you can remain solvent.”
My version of Keynes quote is – Markets can remain irrational longer than a common investor can remain sane.
It’s not sufficient to identify the smell of bull market. More important is to remain calm and unaffected by that raging smell for you won’t know when that bad odour becomes a fragrance to olfactory senses.
The destiny of a clownfish is to reach its anemone. It can’t wait for the acidity of seawater to go away. To reach its destination, the clownfish has to navigate through the landmine of deceiving smells.
Similarly, as an investor you can’t wait for the bull market to settle. What if it doesn’t crash for a long time, as Keynes said. Not investing isn’t a way to deal with bull market.
Being more careful and knowledgeable about your investment decisions is.
Don’t be afraid of the “wall of mouths”. Just work on your sense of smell. Know what you’re getting into. And even if Mr. Market’s euphoria is rocking your emotions everyday, just keep reminding yourself this line from Finding Nemo –
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