Investor Psych 101: Separate Your Emotions From Rules. Hope, Fear And Greed: An Investor's Corner Series First In A Series The stock market is human nature on parade. It's an old saying that's worth repeating, especially as the Investor's Corner kicks off a series on psychology and investing. Because the market involves millions of people, with all of their greediness, hopes and fears, it doesn't behave like a completely efficient machine.
As soon as you realize this fact, and then recognize your own biases, you're on the road to becoming a better investor. IBD's upcoming series will explore a range of aspects. We'll also talk about another contrarian indicator: magazine covers. Academics have even picked up on this trend. Other columns will touch on key biases such as overconfidence and anchoring. With overconfidence, you might refuse to sell a stock even when it's dropped 8% from your purchase price (which should trigger the golden sell rule). This behavior also relates to the idea of anchoring. Investor Psych -- How Sentiment Gauges Help. Hope, Fear And Greed: An Investor's Corner Series Second In A Series Everyone wants a magic indicator that perfectly spots tops and bottoms. There really is no such thing. Psychological market indicators shouldn't be your main tools for timing the market.
Instead, let price and volume be your guide. As IBD founder and Chairman William O'Neil wrote in "How To Make Money In Stocks," "The stock market is human nature and crowd psychology on daily display. " Instead of seeking a Holy Grail indicator, focus on follow-throughs to signal possible market bottoms. Still, sentiment indicators can help you understand crowd psychology. Psychological indicators can give false readings, though. Some indicators work well, then fall out of favor. A number of psychological market indicators can be found on the How's The Market? Two weeks before the Nasdaq topped in late October 2007 1, 62% of investment advisers were bullish vs. 20% for the bear camp, showing excessive optimism. Netflix CEO Reed Hastings' Kiss-Of-Death Cover Story. Hope, Fear And Greed: An Investor's Corner Series Third In A Series Suppose you saw Netflix (NFLX) CEO Reed Hastings on the cover of Fortune in its Dec. 6, 2010, edition and you owned shares in this big winner during the 2009-2010 run-up.
The radiant red cover showed Hastings sitting comfortably in jeans on a tan leather chair and grinning like a high school senior on prom night. After all, the biweekly magazine chose him "The 2010 Business Person of the Year. " Would it have been smart to sell your shares that same day? With 20-20 hindsight, well, yes. And partly no. At the end of November — around the time the magazine hit the newsstands and got zapped into tablet PCs, the pioneering movie rental firm traded at 205.90. The Netflix example reaffirmed how magazine covers often reflect the state of investor psychology after a stock has already made outsized gains. Magazine cover stories tend to be sensational.
But by that time, the stock is already saturated with investors. Tip From NASCAR Star: Don't Let Stocks Hurt Your Ego. Hope, Fear And Greed: An Investor's Corner Series Fourth In A Series "The winner ain't the one with the fastest car," famed stock car driver Dale Earnhardt Sr. used to say. "It's the one who refuses to lose. " Earnhardt knew about getting bumped, and he never let it psych him out of a race. Winners in the stock market play a similar game. Leading stocks have many ways of shaking out weak investors. Sometimes a stock will come under selling pressure after a breakout. The result — a pullback after a breakout — is not uncommon. Generally that pullback will just return for a test of support at the 10-week moving average, then reverse and move higher.
Don't confuse that with losing. Sure, it stings a little. And that opening may come from the stock that shook you out. If it fits the leadership mold and the market is healthy, chances are good it will go on to book additional gains. So keep it on your radar. Make sure you're not looking the other way, licking your wounds when that run starts. Investor Psychology - Why You Should Avoid Low P-Es. Hope, Fear And Greed: An Investor's Corner Series Fifth In A Series Stocks are like motorcycles. The best ones are expensive. If you have your heart set on a brand-new Triumph Bonneville, expect to pay more than for, say a lesser bike from a company you've never heard of. Your portfolio deserves the best stocks, just as you deserve the best motorcycle. Let's examine two ways the market values a stock: price and the price-to-earnings (P-E) ratio.
You should not be afraid to buy a stock as it breaks out, even though you'll be paying more than almost anyone else had ever paid up to that point. But if a great stock is going to break out at say, 30, and rise to 100, it's going to have to start its move at 31, even if that's a new high in price. You may well be the first person ever to pay 31 for that stock. Now consider the P-E ratio, another way investors like to see if a stock is "cheap" or "expensive. " It's derived by dividing the stock's price by its total EPS over the past 12 months. Investor Psychology: Don't Hold An Industry Bias. Hope, Fear And Greed: An Investor's Corner Series Sixth In A Series Some investors routinely avoid certain stock groups or sectors because of a personal bias.
Try to become aware of the sectors or groups that make you uncomfortable. If you learn to expand your comfort zone, opportunities will bloom. Here are some common biases: • Technology: Some people won't buy a tech stock because, "I'm not an engineer, and shouldn't you understand what you're buying? " We're not recommending ignorance as a strategy. . • Gold miners: Some investors avoid gold stocks because "gold has no intrinsic value" or because they associate such investments with gloomy survivalists. The "no intrinsic value" argument has no value. . • Pharmaceuticals: The fear here is that an ethical drug is "only one bad FDA ruling away from a gap-down loss. " • Upscale wares: Frugal people will sometimes avoid the stock of companies that rely on sales of "products only a fool would pay up for.
" In 2008, oil stocks led the breakout show. Don't Rely On Stock Tips; Do Your Own Homework. Hope, Fear And Greed: An Investor's Corner Series Seventh In A Series Hey, here's a stock tip for you. Ready? This is it: Don't listen much to stock tips. One key psychological problem for investors is that many give too much weight to other people's views. It's OK to listen a little to these opinions. You really have to do your own research, which takes time. William O'Neil, IBD's founder and chairman, wrote: "Many people are too willing to risk their hard-earned money on the basis of what someone else says, rather than taking the time to study, learn and know for sure what they're doing.
" He has warned against buying solely on tips, advisory-service recommendations or advice from analysts or other market experts. OpenTable (OPEN) provides a good example of how relying on opinions could have been hazardous to your wealth. The provider of Web-based restaurant reservations has been in a steady, even steep, downtrend since early May. Keep It Simple: Don't Go Long And Short At Same Time.
Hope, Fear And Greed: An Investor's Corner Series Eighth In A Series Simplicity is a good thing. Investing should also be kept simple. Investors should be either long, short or simply waiting on the sidelines at any one time. A big part of making money is being on the right side of the market at the right time. In a bull market, focus on top-rated companies. Remember that the direction of the market has a lot to do with whether you'll have a winning or losing trade. Investors should only be shorting stocks in a bear market.
Trying to play both sides can be costly. When the market ushered in a new uptrend with a follow-through in March 2009, that was the time to buy stocks. Hedging a position with options and futures can make life more complicated and create potential problems. For example, you can sell call options on a stock you already own. But by selling the call, you've capped your upside potential. Instead of using derivatives, your best hedge is to keep things simple. Know The Three-Waves Rule In Bear Market Declines. Hope, Fear And Greed: An Investor's Corner Series Ninth In A Series Most classical music is written to the rhythm of three or four beats a measure. Having a set meter helps give a waltz or a symphony coherence and order. Coincidence or not, major market declines also weave a similar pattern. If you study bear markets, you'll see they didn't quite go down in one fell swoop, like a logging tree.
Instead, they form over three or four waves of intense selling. In between those selling waves, a major stock index might rally a month or two. As a savvy individual investor or a nimble fund manager, you want to shift to the sidelines as major market declines develop. Also know this: IBD research shows the typical market leader, once it's finally topped, drops on average 72% from its high.
The table points out the waves of selling during two of the worst U.S. bear markets ever. So, when do you get greedy? The great Nasdaq winners after the 2000-02 bear died echoed that wisdom. Too Much Trading Can Make You Miss The Big Winners. Hope, Fear And Greed: An Investor's Corner Series 10th In A Series "Helicopter parenting" is a label slapped on moms and dads compelled to hover over their kids to defend them from and usher them through even life's most minor challenges.
Such micromanaging is widely considered ineffective, even damaging, parenting. The same holds true in the investing trade. A helicopter investor would be one who overtrades. Overtrading may also involve hopping repeatedly from one stock to another, always seeing weeds on this side of the fence, flowers on the other. He or she may also feel compelled to dive into a battle with a choppy market, too eager to take a breather while volatile circumstances sort themselves out. Buy Right And Hold On The antidote to all these foibles is a mix of patience and discipline.
Buying at the right time helps a lot. Buying too long after the breakout may trigger the 8% loss-cutting sell rule. All of these factors can set you up for another quick sell. Don't Let Ego Paint You Into A Dead-Money Corner. Hope, Fear And Greed: An Investor's Corner Series 12th In A Series The need to be right can paint investors into a corner. When that happens, you can pretend you're a long-term investor who intended all along to sit on the floor and wait for the paint to dry.
But saving face wastes time and money. How we get ourselves in such messes is a question for philosophers and psychiatrists to answer. Smart investors should not be much interested in why bad things happen. The messes can include ignoring the 7%-8% sell rule because you're convinced you're right about the stock; buying a stock with faulty fundamentals because your gut feeling tells you it will be a big winner; and averaging down because the market is "mispricing the stock.
" Now, we could say, "Don't do that! " Here are three preventive steps to consider: • Construct a fence of silence around your trades. . • Trim your sources. Most of your time should be focused on the price and volume action of the market itself. Stick With Pure CAN SLIM; Don't Mix Strategies. Hope, Fear And Greed: An Investor's Corner Series 13th In A Series It's a bad idea to follow just some of the rules of the road.
Let's say you obey the speed limits and stay to the right side of the street. But you're not a fan of stopping at red lights or slowing down at yield signs. Well, that isn't going to end well. It can be similarly bad if you take a pick-and-choose or a-la-carte approach to IBD's CAN SLIM investing strategy. The strategy is designed for growth investors to follow in full. If you pay attention to only 50% or 75% of the rules, you're likely to get hurt. Even so, this problem — not following all of the rules — pops up a lot. Many IBD readers fall into the trap of mixing their own biases with CAN SLIM, while also perhaps adding a few ideas from some other investing strategies, charting services or newsletters. These investors — let's call them "overconfident mixers" — are sure they can create a hybrid approach that's even better than pure CAN SLIM.
They're often men. Don't Let Greed Blind You; Take Stock Gains At 20%-25% Hope, Fear And Greed: An Investor's Corner Series 14th In A Series In the 1987 classic "Wall Street," Gordon Gekko said, "Greed is good. " But in reality, being greedy may not be so good. Trying to squeeze out every last bit of gain can backfire. And as IBD Chairman William O'Neil wrote in "How to Make Money in Stocks," "The object is to make and take significant gains and not get excited, optimistic, greedy, or emotionally carried away as your stock's advance gets stronger. " Investors need to stick to sound selling rules. One way to do that is to book profits once a stock goes 20% to 25% past a proper base buy point. There is no way to know if a stock will go up 20% to 25% after it breaks out. First, you lock in a gain. Just because you bought a leading stock that just broke out of a picture-perfect base in huge volume doesn't guarantee it's going to be a huge winner.
So, following this strategy can help investors achieve a win-loss ratio of 3-to-1. How To Invest: Nix Fear On Stock Market Buy Signal. Hope, Fear And Greed: An Investor's Corner Series Last In A Series "Major buying points often occur without a full scale actual business depression. At such times the fear of a depression exists. " (G. Loeb, "The Battle for Investment Survival") "Through the years, I've found that when you get a follow-through, the vast majority of investors simply do not believe it's for real.
They are scared to death. "I feel my success comes from my love of the markets. Fear is good for mankind's survival. Kids learn it's not a good idea to put a hand in the fire. But when it's time to buy stocks, it's often when fear fills the air like a thick fog. The best time to buy great stocks is in the days and weeks after the market has turned. As true market leaders build their gains and climb the wall of worry, the media often will bombard you with negative opinions, sour headlines and bad news. Forgetaboutit! On Sept. 1, 2010, the Nasdaq vaulted 3% in heavier volume 1. Hope, Fear, Greed: Don't Let Hope Steer You Wrong. Hope, Fear And Greed: An Investor's Corner Series 11th In A Series Hopes and dreams. These are the things that keep us going. They may even be the fuel behind your investing ardor. But don't let any emotion — especially hope — guide your investing decisions.
Looking for excuses to ignore your rules will get you into trouble. Mistake No. 1: Buying ahead of a breakout, hoping to gain a few extra points. How many charts of successful breakouts have you seen? Why wait for the breakout? And how many times have you seen the price push higher, only to find poor volume and no interest from new buyers above the trigger? Mistake No. 2: Not cutting losses, hoping your pet stock will return to break-even. Ignoring the cardinal rule is a cardinal sin.
Mistake No. 3: After realizing the stock has already triggered one or two great topping signals, not taking any action and hoping it will return to its highs just one more time. This is a classic case of letting your hopes lead you where you shouldn't go.