Friday, July 27, 2007

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,

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