The following investment rules are made especially for tough investment environments (such as now). These rules give good investors a plan to follow, just when they need it the most. The following 9 rules are especially useful in times of extreme market volatility or when the markets are irrational.
Markets will eventually return to the average.
When stocks go too far up, they will come back down. When stocks fall too low, they will come back up. Market excess in either direction will eventually disappear, and the markets will go back to the average. It’s far too easy for investors to follow the herd and lose a proper, rational mentality.
Irrationality in one direction will lead to irrationality in another direction.
If the markets are europhic (in a big bubble), then once that bubble is popped, the markets won’t simply fall to a slightly undervalued price. The markets will fall to a level where investors are totally fearful and irrational. Think of the financial markets as a rubber band Any pull that’s too far in one direction won’t only bring you back to the baseline, but leads to an overshoot in the opposite direction.
“This time is different” does not exist.
Investors are always attracted to the “new thing” (a.k.a hottest industry in town). Eventually, a huge bubble is inflated by europhic investors believing that “this time is different.” Remember the tech bubble? People where quoted saying things like “this is a new economic paradigm where everything is free, stores like Wal-Mart will be destroyed by online retailers, etc.” Of course, “this time” isn’t really different. Investor psychology (human psychology) never changes. Eventually the bubble pops, and investors are left with an ever increasing red number on their screen. It’s far too easy to get caught in the heat of the moment, and mom and pop investors are usually the ones who get creamed by market excesses.
Rapidly inflating or deflating markets usually go further than you’d think.
Bubbles or panics usually last longer than anyone would have thought. But don’t expect a bubble to plateau and stay like that forever. Bubbles may plateau at the top, but eventually they’ll fall. Hard.
Mom and pop tends to buy near the top, and sell near the bottom.
Mom and pop investors are the least knowledgeable of all investor types. They buy whatever is hot and everyone is europhic about, and sell whatever everyone else is selling and fearful about.
This is the reason why good contrarian indicators exist. A good contrarian indicator gives out buy signals at times of maximum market bearishness, and sell signals when the millions of moms and pop are buying like crazy.
Most investors do not have the resolve to stay true to their long term resolve.
Most investors simply cannot control the emotions of fear and greed within them. Hence goes the saying “you are your own worst enemy.” You may have intended to hold onto your investments during a bear market, but the fear in you forced you to sell at the bottom of the bear panic.
When the market leaders are no longer the leaders, you know that the end of the bubble is approaching.
During times of extreme market optimism, there are always market leaders. There are always stocks that perform the best out of the whole market. When the leaders (stocks that performed the best) start falling, you know that the end of the bubble is close. When the second wave of market leaders start falling, you know that the end of the bubble is even closer.
Longs are easier to play than shorts.
If your long investment position doesn’t work out, you can always afford to hold onto that position (assuming that you’re not using leverage). But shorting stocks is far more difficult than being on the long side. Shorts require immaculate timing, because you can’t afford to hold out against market conditions that are unfavorable to your short position (you’ll be forced to close your position). As famous hedge fund manager and author once said, “shorts are not for sissies.”
When all the experts agree on a general market direction – the opposite is likely to happen.
One can never fully trust the so called “experts” and economic advisers. Half of them have never had any real experience out of financial theoretic, hence, they haven’t a clue of what works and what doesn’t in the real world of investing.
Going against the herd can be very profitable, especially for patient buyers who raise cash from frothy markets and reinvest it when sentiment is darkest. Warren Buffett once said “be fearful when others are greedy, and greedy when others are fearful.” That contrarian investing. However, I beg to differ from Mr. Buffett’s saying. “Be fearful in times of maximum greed, and greedy in times of maximum fear.”
Markets strengthen when the tide lifts everything, but weakens when only a select few fly sky high.
The saying “there’s strenght in numbers is true.” A broad, powerful market movement in which everything rises or everything falls is strong, and thus, hard to stop. Conversely, when all the money crowds into a few select stocks, many other attractive and undervalued stocks are overlooked. Remember the “nifty 50” of the 1970s? Almost all the market gains went to these 50 big companies, and once those companies soared to far up, they all came crashing down.