Are You a Frog in Boiling Water?

One man who has had a deep impact on my thinking as an investor is Charlie Munger, Warren Buffett’s partner at Berkshire Hathaway.

I’ve read a lot about Charlie over the years. Among his writings and speeches that have impressed me the most is the speech that he gave at the Harvard Law School in 1995.

The speech was titled ‘The Psychology of Human Misjudgment’, and it contained his views on human behavior and how we misjudge events to make poor decisions in our daily and investing lives.

In this speech, Munger cited a small lesson from frogs. He said:

“If you throw a frog into very hot water, the frog will jump out, but if you put the frog in room temperature water and just slowly heat the water up, the frog will die there.”

This speech was given way back in 1995. So we can expect the current generation of frogs to have become intelligent enough to understand this mystery.

But this ‘frog in boiling water’ syndrome continues to play out when it comes to investing in stock markets.

Let me explain.

When stock prices rise or fall fast, as shown in the graph below, investors get in (buy) or get out (sell) of them. They instantly know that the water is already very hot, or very cold, so they jump out fast.

But when the rise or fall in stock price is slow (like the slowly heating up water), investors take it casually.

They become passive…like the frog that soaks in the warmth of heating water without knowing that the same water will ultimately boil and kill it.

For investors, the gradually but ever-rising market is like that heating water, and the peak of stock prices is the boiling point.

But why am I telling you all this?
You might be wondering why am I telling you all this.

After all, you aren’t a frog. And the water (stock markets) isn’t boiling either.

Yes, dear investor, the water isn’t boiling as yet. But it is definitely heating up.

Let me cut it short here and tell you that we are seeing something similar (to the ‘frog in boiling water’ syndrome) panning out in the Indian and global financial markets.

We have already seen the Indian economy get back on its feet after the slowdown of 2008 and early 2009. We have also seen the recovery in stock prices from their lows of March 2009.

But as you must note, a large part of this recovery has been fueled by cheap money (printed by western central banks) sloshing around the world. And when there’s too much (free) money chasing few high-return assets (like Indian and other emerging market stocks), the result is asset price inflation.

While Indian stocks haven’t seen any drastic fall since touching their highs in October 2010, valuations remain fairly reasonable especially when seen in context of the new emerging dangers to the economic recovery.

You see…

• Inflation in India remains high.
• Interest rates are rising as a consequence.
• Companies are postponing their expansion plans.
• Individuals are not borrowing to buy new homes and automobiles.
• Corruption is rampant.
• Reforms are moving at extremely slow pace.

But as stock market pundits will tell you (with high hopes as always), stock prices already factor in these concerns.

Okay, okay!

But…

• What about the issues plaguing the western markets?
• What if the US or a major European economy goes bust as they seem so likely now?
• What if China’s economy plunges given the overheating it is already seeing?

Remember, the way Indian markets move (up or down) has a lot to do with the way the western economies and China perform. Any major setback there, and all will come crashing down here…like it did in 2008.

“Why are you scaring me?” you may ask.

See, I am not scaring you, dear investor. I have your best interest in mind. That’s why I’m warning you.

Don’t give in to the words of people who might advise you to buy stocks as ‘they appear cheap now’.

You might hear explanations like…

• We are past the bad phase.
• The Indian economy remains on a robust growth path.
• Stocks are cheap, so you must buy them now.
• We are just at the start of a massive bull-run in mid and small cap stocks.
• Have you heard of that wonderful investment opportunity?

But stay alarmed, dear investor.

As we see from the perch of Safal Niveshak, stocks in general aren’t very expensive but they aren’t cheap either. Corporate earnings are not showing signs of sustaining, and we will soon be in a phase where companies start to revise their growth projections downwards.

Before they do that, and before the stock market experts change their track as well (like they do with every whiff of air), it’s important that you get cautious with your stock investing.

It pays to be patient (not casual). Wait for the right valuations, and believe me, they will come.

After all, you would not like to be the frog enjoying its time in the heating water, only to burn later.