Warren Buffett once said that it is wise for investors to be “fearful when others are greedy, and greedy when others are fearful.”1 This statement is somewhat of a contrarian view on stock markets and relates directly to the price of an asset: when others are greedy, prices typically boil over, and one should be cautious lest they overpay for an asset that subsequently leads to anemic returns. When others are fearful, it may present a good value investment opportunity.
Since the price is what you pay, and value is what you get, paying too high a price can decimate returns. To elaborate on this, the value of a stock is relative to the number of earnings it will generate over the life of its business. In particular, this value is determined by discounting all future cash flows back to a present value, or intrinsic value.
Pay too high a price and the return that arises as a stock gravitates back to its intrinsic value over time will erode. Act greedy when others are fearful and reap enhanced returns under the right set of circumstances: predictability must be present, and short-term events that create the subsequent downgrade in prices must not be eroding. Here's how Buffett did it.