Emotions Over Experience

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Emotions Over Experience

By Dr. Steve Sjuggerud, President, Investment U
Friday, February 28, 2003: Issue #217

What makes you pull the trigger and buy?

Think back to the last time you bought stock, did you say something like, ‘I’d better get in before the market goes up some more!’ Or was it ‘I’m going to double down on this loser to lower my average cost!’

Whatever the reason, the actual trigger to buy was probably EMOTIONAL, not RATIONAL. And that’s NOT a good thing. The truth is, investing like this is dangerous to the health of your wealth. But if you can rise above the temptation to invest based on emotion – it is possible to make money by recognizing the emotions of othersand investing appropriately.

Today I’ll show you a few simple ways you can do just that – recognize when the emotions of other investors hit extremes, and then profit from their irrationality. (Here’s a hint: In order to profit, you’ll have to be willing to go against the crowd)

The ‘I Gotta Get In’ And ‘Double Down On Your Losers’ Syndromes

It seems that emotions are much more powerful than rational thought when it comes to individual investors. One example of this is the ‘I gotta get in’ syndrome. Most investors are ‘rear-view mirror’ investorsthey expect the immediate investing future to equal the recent investment past. So many people, seeing the Nasdaq up wildly in 1998 and 1999, said, ‘I gotta get in on that.’ Not a good idea.

Another example is the ‘double down on your losers’ syndrome. As investors, most of us are averse to taking losses. (Althoughif you remember, the Golden Rule of Investing is to ‘Cut Your Losers Short and Let Your Winners Ride.’ Accepting small losses is part of being an investor. The key is to keep those losses small.)

So one way that people try to avoid taking a loss is to ‘double down’ on itor, put another way, to actually buy more of the stock as it falls. But, again, this is simply emotion winning out over rational thought – a stock doesn’t care what price you paid for it.

Emotions Have Come To The Forefront In The Past Week

This week I’ve seen two big examples of emotions overtaking rational thought. First, I’ve received a pile of hate mail this week for a biotech stock that tanked that I supposedly recommended. Yet I haven’t ever recommended or bought a biotech stock. The reason I’ve never bought one is simple: I don’t know anything about them. (The stock – Vaxgen – was actually recommended by Porter Stansberry. Porter is a good frienda good newsletter writerand an excellent biotech analyst. I have endorsed Porter many times, and still do. I believe he’s still holding the stock.)

Second, I received another pile of hate mail for allegedly expressing my war opinion in Tuesday’s IU E-Letter. All I said was that my opinion about the war – like the opinion of many entertainers – is not particularly valuable. I don’t have expertise or knowledge that helps. Of course I want as few casualties as possible in the end. But you won’t find me on Colin Powell’s speed-dial.

These were two emotionally charged issuesand emotions are hot right now. Here’s how I knowand how to profit from them

How To Measure The Emotions Of Investors

First, stocks rise at an annual rate of 31% a year when individual investors are distraught. They rise at an annual rate of 1% a year when individual investors are optimistic. I came up with these numbers from the American Association of Individual Investors (www.aaii.com) weekly survey of individual investors, published in Barron’s every week.

AAII asks individual investors if they are bullish, bearish, or neutral over the coming six months. I simply get a ratio that shows the number of bulls as compared to those expressing an opinion. (So that would be Bulls divided by Bulls+Bears, for those of you scoring at home.) I use a four-week average, to smooth out wild swings.

Right now, as I write, individual investors are more bearish than they’ve been in a decade. And as you know, a decade ago would have been a good time to buy stocks. If you’d like to follow at home, anything below 48 means individual investors are very scared, which may mean we’re in for a near term rally. Anything over 68 means individual investors are exuberant, and we may be at a near term peak. The latest numbers show just 21% of those surveyed are bullishwhile 59% are bearish! Clearly, individual investors are distraught right now.

Another ‘contrary’ indicator like this that gauges emotion is the Consumer Confidence Index. One such index is put out by the Conference Board, while another is put out by the University of Michigan. Again, the results are similar. When consumers are overconfident, we don’t make money in stocks. And when consumers are extraordinarily dejected, we can make a lot of money in stocks. Over the last 34 years, stocks have risen at an annualized rate of 26% a year when Consumer Confidence falls below 66. Today we’re at 64.

What Do The ‘Pros’ Think?

So the individual investor is feeling particularly beaten down at the moment. The problem is, the pros aren’t feeling beaten down yet (can you believe it?).

For sentiment of the pros, I follow the surveys done by Consensus Inc. (www.consensus-inc.com), Market Vane (www.marketvane.net) and Investors Intelligence (www.chartcraft.com). These surveys get me on the pulse of how the pro is feeling. And the pro is not dejected yet. Generally at true market bottoms, both the pros and the individual investors are dejected.

All these studies are quoted in Barron’s weekly. You don’t need any fancy formulas to figure out what they’re telling you. When the percentage of bears increases to near the number of bulls (or even surpasses it), we should be near a bottom. And when the percentage of bears is very low, we may be close to a new high.

Heck, you may not even need Barron’s. Do your own survey just keep your ears open for the stock market chatter at your next social get-together.

Getting back to where we started, chances are you’ll be better off if you make your investment decisions more on rational thought and less on emotion. It is much harder than it sounds.

Good investing,

Steve

Today’s IU Crib Sheet

Remember this quote, from 1951’s The Art of Contrary Thinking by Humphrey Neill: ‘When everyone thinks alike, everyone is likely to be wrong.’ If you really want to make a mint through investing, you’ll have to have the strength to go against the crowd at extremes – when everyone is thinking the same thing except you.
Earlier in this message, I mentioned that I have never, in fact, purchased or recommended any biotech stockfor the simple reason that I do not understand biotech stocks. But I do make specific investment recommendations each month – with a good measure of success, I might add – in my own newsletter, Steve Sjuggerud’s True Wealth. For more information on True Wealth – including how you can get started right away – please click here.
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