Psychology 101: Investor Panic! ... Time to Buy?

The U.S. stock markets have dropped 4% this week, and investors' fear levels are near the yearly highs set in March. Investor psychology is a funny thing -- but it's predictable -- and understanding it can make you a lot of money.

We've been mentioning in our blog posts over the past 2 months that as the stock market has gone higher, investors have grown more and more nervous. They have felt inclined to sell to "cut their winners short" just to lock in their gains so far. A brief market sell-off is exactly what drives investors to feel afraid when they've already made so much money.

Let me offer myself as an example. Every 6 months I create a 10 stock portfolio using a basic Yahoo! stock screener and a little due diligence (calling company CFOs, reading SEC filings, etc...). Takes me about 8 hours to complete the whole process, and the average return has easily been over 20% annually. Here are some of the older portfolios (which I stopped posting after 2005 due to time constraints). This January's portfolio is already up 25%. Which is obviously better than anticipated.

Frankly, that 25% 8-month return scares me. My account is 25% larger in only 8-months. Wow, it feels good. However, like almost everyone else, I want to take that money off the table so I don't lose it. I'm susceptible to cutting winners short. Why don't I? Because I know that my nervousness is not a trading plan, it's a road to underperformance.

Using our Marketpsych sentiment analysis tools, we've been watching the pain level rise over the past week. See this Marketwatch article (which mentions our Investor Pain Index) for a few details. The chart below was generated using our real-time proprietary sentiment software and it is plotted against the QQQQ (Nasdaq 100 ETF):
This chart shows the relative amount of pain measured among investors.

As you can probably see in the chart, the last time pain was so high was a great time to invest. So consider using stomach-churning pain as a Buy indicator. You don't need to "catch the falling knife," but you may want to enter buy stops slightly above the market, because any "relief rally' will be fast and furious.

Personally, I think the pain will probably spike again (and the market will sell-off), in a second wave, before a real buying opportunity presents itself (August and Spetember are yet to come). Consider investing some idle cash during an August sell-off, although also consider somewhere safer than the US dollar (e.g. Singapore or Malaysia) when those markets get hit.

Best wishes,
Richard

The Fiddler's Green: Curse of the Adjustaholic

It was Blaise Pascal, the brilliant French mathematician, physicist and philosopher who said:

"All of men's miseries derive from a single source; his inability to sit peacefully in his room."

Pascal was not referring specifically to investing -- but he certainly was including it. We love to tinker, adjust and monkey with. At least I do.

My name is Frank, and I am an adjustaholic.

My affliction began early in my youth. I would fiddle incessantly with the old rabbit ear antennae on the "television set" in a futile effort to achieve picture perfect clarity on a 1974 Magnavox. I would indulge in impulsive, hare-brained schemes such as throwing the football in an effort to knock the frisbee out of the tree. And then throwing the tennis racket at the football.

By 5 o'clock the tree on my lawn looked like Dick's Sporting Goods.

Sure. I could have waited patiently for my dad to come home and retrieve the offending object. Could have for 2 minutes that is, before the restlessness set in.

I'm older now. I have an HD TV and I don't play much frisbee anymore. But I am still a fiddler.

It raises to mind a behavioral finance question: What is to become of the Fiddler's Green? I'm not referring to the traditional Irish song (which is great by the way), but to the financial portfolio of the modern adjustaholic. If you are an adjustaholic like I am, there are some days you have an urge to fiddle. Somedays you just wake up, get a cup of coffee... and you just really feel like buying a stock.

Any stock.

I'm gonna do it. I'm gonna buy... geez, I dunno... something in the IBD top 10! Like SYNL! And why not? It's # 1 on their list for crying out loud! What exactly does SYNL do? They print $$$ for their investors, THAT'S what they do! It's up to 45. Have you seen the chart! It's a rocket ship! Besides, I'll just cut my losses at 8% if it drops. (And I really will this time too.) But it won't drop! That's the beauty of it! You may say I'm joining a game of Musical Chairs at the Greater Fools Social Club, but they're playing the live version of Freebird - and they haven't even gotten to the guitar solo yet!

Do I really need to tell you what happened next? Suffice it to say I capped my losses at 8% this time. (Okay, 10%). And the fiddler loses some more green.

I recently had a conversation with my colleague, Dr. Peterson. I stated that we cannot change human nature, but that we could plan around it.

Dr. Peterson pointed out that the same human nature that bedevils our investing process is equally apparent in our planning processes.

He has an undeniable and somewhat depressing point.

Well, I still believe we CAN plan around human nature, but it is not easy. It requires honesty with ourselves and self-awareness. It requires having, at the ready, a behavioral alternative that is less self-destructive than placing a buy order. Sometimes it may require help. One of the best things a busybody investor can do is to have a partner - a financial advisor, a friend - someone they can call in his/her moments of weakness.

I'm serious. Alcoholics Anonymous, Gamblers Anonymous, Smokers Anonymous -- one of the most effective methods of stopping a destructive behavior is to reach out to another person when your will is faltering. It helps.

Pascal was right. I cannot sit peacefully in my room, the one with the computer in it... and the access to my brokerage account.

Next time I feel the urge to buy SYNL, maybe I'll call Rich. Or maybe I won't bother to sit in my room at all, and I'll go for a long, long walk instead.

IT'S HERE: Inside the Investor's Brain

After a year-long writing odyssey, it's with great excitement that I announce the release of my new book, Inside the Investor's Brain. You can purchase the book here: Inside the Investor's Brain: The Power of Mind Over Money (Wiley Trading).

The ability to manage your mind in the markets is necessary for long-term trading and investment success. This book teaches the science of achieving high investment returns through an understanding of the power of mind. Endorsements are here. I won't repeat the publishers's long blurb (here: Inside the Investor's Brain: The Power of Mind Over Money (Wiley Trading)), but below is the table of contents:

Introduction.

PART ONE. FOUNDATIONS: THE INTERSECTION OF MIND AND MONEY.
Chapter 1. Markets on the Mind: The challenge of finding an edge.
Chapter 2. Brain Basics: The building blocks.
Chapter 3. Origins of Mind: Expectations, beliefs, and meaning.
Chapter 4. Neurochemistry: This is your brain on drugs.

PART TWO. FEELINGS AND FINANCES.
Chapter 5. Intuition: The power of listening to your gut.
Chapter 6. Money Emotions: Clouding judgment.
Chapter 7. Joy, Hope, and Greed: Hooked on a feeling.
Chapter 8. Overconfidence and Hubris: Too much of a good thing.
Chapter 9. Anxiety, Fear, and Nervousness: How not to panic.
Chapter 10. Stress and burn-out: Short term pleasure, long term pain.
Chapter 11. Love of Risk: Are you trading or gambling?
Chapter 12. Personality Factors: What are great investors like?

PART THREE. THINKING ABOUT MONEY.
Chapter 13. Making Decisions: The effects of probability, ambiguity, and trust.
Chapter 14. Framing Your Options: Seeing the world in black and white.
Chapter 15. Loss Aversion: Cutting losers short and letting winners run.
Chapter 16. Time Discounting: Why we eat dessert first.
Chapter 17. Herding: Keeping up with the Jones’.
Chapter 18. Charting and data mining: Reading tea leaves.
Chapter 19. Attention and Memory: What’s in a name?
Chapter 20. Age, Sex, and Culture: Risk-taking around the world.

PART FOUR. IN PRACTICE.
Chapter 21. Emotion Management: A balancing act.
Chapter 22. Change Techniques: Going deep.
Chapter 23. Behavioral Finance Investing: Playing the players.

Notes.
Glossary.
Index.

It is my sincere hope that Inside the Investor's Brain will help you achieve investment (and life) success beyond your wildest expectations.

Richard