The Psychology of Investing, a quick overview!
The psychology of the market dictates the ultimate valuation of securities. Whether analysts or investors believe a stock should be valued at a particular price, it is the psychology itself that drives valuation levels. In the depths of a bear market, emotions are high and liquidity concerns drive valuations. Valuation levels are driven well beyond where securities should be priced. At the height of a bull market, the opposite extreme is at work. Investors believe that stock prices have nowhere to go but higher.
Markets tend to top out due to complacence and then are driven lower as the herd starts to realize that there is a change in direction underway. Fear tends to occur at bottoms. The VIX (a stock volatility index also known as the fear index), the ultimate fear indicator of the market is a barometer to the health of the market. A high number on the VIX reflects an extremely weak market and therefore a bottom should be coming. When panic sets in, the opportunity for investing is lurking around the corner. A low number on the VIX reflects complacency or a topping process. Look out for a declining market.
You must be as judicious with your selling as you are with your buying. Many retail investors sell too often and too soon. They are always looking for a reason to sell as opposed to a reason to buy. They rarely make appropriate returns for their holdings. Often when they buy stocks at the wrong price, they typically sell the shares when they break even once again. Fear keeps them from realizing appropriate returns.
Long term investors typically become short-term traders whenever they are faced with a falling market. Market volatility typically creates opportunity to the well-informed. Wait for good valuation points and add to your holdings. Consult a professional if you need an extra hand in managing the psychology of the markets.
Robert Floyd, CFA, is Lead Manager for BirchLeaf Investments (www.birchleafinvestments.com)
