Sunday, 28 August 2011
The cycle of market emotions
I find this a good depiction of mass human psychology in the stock market. Look at how most of the investors feel when they are riding up a bull run – “excitement”, “thrill”, and “euphoria”! Alan Greenspan would have called it irrational exuberance. It is indeed the greed and behavior of the investors that drove the price up into a self fulfilling prophecy – the share price is going up, let’s invest. The more money gets thrown into the market, the higher the share prices go. The masses continue to do it to a point that no more greed is able to sustain the run.
When the downturn begins, many (denial) investors will want to ‘believe’ they have made the right investments and will continue to ‘believe’ the stock will rebound. Often, they will call themselves long term buy and hold investors when they admit that a short term gain is not realized.
As the downturn worsens, “fear”, “desperation” and even “panic”, create another self fulfilling prophecy – the share price is falling, we need to sell. The more they sell, the more the prices will drop.
So how do you capitalize on market emotions? It really depends on what kind of investor you are. I believe there are 2 kinds of investors that will probably make the best out of such situations.
Value Investing
The first would be the value investors. The point where they are likely to make investment will be between “capitulation” and “depression”, also denoted in the diagram by “point of maximum financial opportunity”. The fact that I stated a region rather than a point is because I believe not all value investors are able to locate the point where market bottoms, and it would be already profitable by buying around the region of bottoms. Thereafter, they will wait out for the next bull run to sell for profits.
It is apparent that the person who came out with this diagram is a value investor since he feels that the maximum opportunity is at the bottom of the market. Trend followers on the other hand, would see opportunities throughout the cycle.
Trend Following
Trend followers would follow the crowd riding up the bull run. The difference between them and the mass investors is that they will liquidate their stock holdings when the market begins to reverse, while the mass investors will still hold on to their stocks. After confirming the downtrend is valid and strong, trend followers would short the market, making money as the stock prices go down. Hence, trend followers are able to make money in both up and down markets, bull and bear runs.
Understand the characteristics of trend following as an investing strategy:
The diagram shows a typical trend following model. Read further to understand the characteristics of trend following as an investing strategy:
Contrarian market psychology
The masses have often proven themselves wrong. Many so-called investors have short term price memory such that when they see a stock drop in price, they will think it is ‘cheap’ to buy. But more often than not, this ‘cheap’ stock would continuingly drop further in price! Trend followers on the other hand, would only buy a stock when it proves that it has the momentum to go higher, usually when the stock breaks new high and while the Majority thinks it is too ‘expensive’. The Majority only knows how to buy a stock up in price to gain profit, but not know how to profit from a stock’s drop in price. Trend followers practise shorting of stocks, which allow them to ride the trend even during a market’s poor run.
Emotionless, mechanical and automatic system
Humans have emotions even when they are investing. Trend followers believe emotions are detrimental to investing. Majority of the investors usually hold onto losing stock and ‘hoping’ that the stock will regain its value, and tend to sell off their stock early for a small profit as they ‘fear’ they may lose the profit. Thus, in order to removed such negative emotions, trend followers have a system of rules to instruct them when to enter and exit the market. In addition, they would have a computerised system with their technical analysis algorithms installed to filter out stocks based on their rules. They want to detach themselves from the stocks – “Do not fall in love with a stock” or “get married to a position” – and this is one of the most difficult challenges.
Pre-determine entry and exit points, and allowing profits to run cutting losses
Majority of the investors get in the market without knowing when to get out. This would allow emotions to take hold of their decision-making process as the market moves. They would then tend to hold on to losses and take profits too early. Trend followers know what price they shall enter and exit the market. They would cut loss when the market has proven them wrong and let the profits run when they are right. The ability to detach their emotions has allowed them to cut loss without thinking twice. This is vital to their survival as they know they cannot be right all the time and they need to minimize their losses – Live today in order to fight another day. By allowing profits to run, over the long run, these large profits will be able to offset the small losses to achieve capital gain.
Price is the main indicator – employment of technical indicators while company fundamentals carry little importance
Trend followers believe price of a stock provides the most clues than anything else. Price suggests trends and they are to follow these trends – Do not fight the trend. Many times, they buy stocks without even knowing what businesses are these companies into, lest to say analysing their fundamentals in annual reports. They would employ technical indicators like moving averages to assist in identifying stocks to buy. Usually, each trend follower will have his/her own selection of a few technical indicators to form a trading system.
Short term and no buy-and-hold
In a bull market, there will be mini-bear periods and vice versa. Thus, a price trend does not last very long – the longest being several months. Trend followers are considered short term investors because they exit trade once the trend reverses. They do not believe in holding on to losses or investing for the long term.
Sounds like gambling and cruelty of a zero-sum game
It may sounds like trend following is gambling but unlike the latter, it does not make predictions. It basically uses indicators and rules to determine the trend and follow it. Gambling depends on pure luck but trend following depends on the accuracy of the trading system and mastery of personal psychology to increase their probability of winning in the market. This means that for a trend follower to win, someone has to lose. On the other hand, it looks more ethical for a buy-and-hold investor to invest in sound businesses to improve economy and at the same time, receive capital gain for his/her investment. However, we need to remember for a company to succeed and increase in profits, its rivals and other industries have to take lesser profits or even go out of business. It is a zero-sum game too, just that it does not seem so direct.
Market Emotion Cycle
EMOTION AND COMMOTION
Market Emotion Cycle
(click for larger picture)
Fear and Greed tend to rule at market tops and bottoms. In the movie “Wall Street” Gordon Gekko says Greed is Good as the market soars higher. In market parlance the opposite of Greed is “Fear” which is bad for Investments. The market has a tendency to scare people out at the bottom and suck them in at the top. The market emotion cycle sees optimism turn to excitement, the thrill leads to euphoria and “Greed” slipping to anxiety, denial and “Fear” followed by desperation panic, capitulation, despondency ,depression, disgust and doubt. Globalization is upon us with what happens half way around the globe reported immediately and reflected in equity and bond market prices with virtually no delay. The problem is the global attitude influenced by events turns cold and hot with every movement.
The international investor attitudes changes in sync with yesterday’s news reports. It is necessary to filter out news & views and find a comfortable way to invest through thick and thin, good and bad, bullish and bearish. The World of investments has become 24/7 with no down time to reflect on issues before human emotion has reacted. This has caused cycles of “Market Emotion & Commotion”. The rollercoaster of emotional reactions are addictive and contagious moving from one time zone to the next. Now is the time to carefully choose individual stocks based on their merit and not by recent popularity.
There are many opportunities to make money but it requires action on your part, each stock selected must show risk/reward of at least 2:1.
What is Wealth Shift?
What is Wealth Shift?
Wealth Shift is the term I’ve coined to describe all the ways that people have found to grab cash and other things of monetary value for themselves based solely on their own judgment and not on any stated agreement between themselves and others.I’m not just talking about a little petty theft, here. I’m talking about a national phenomenon – a competition of unparalleled greed – one that is responsible for some of the biggest problems facing America today.
Look at Wealth Shift in the world of business. At the lower levels of an organizational chart, once-ethical employees are now Wealth Shifting with impunity by helping themselves to company supplies, taking extra-long lunches and mental-health days, and by accessing the internet on company time. Recent studies show that these and other seemingly innocuous offenses add up to nearly 40% of base compensation when taken as a whole. But Wealth Shifting isn’t limited to rank and file employees. Executives have become infamous for structuring perk-laden compensation plans for themselves and then using the complexity of those plans and loopholes in the financial reporting rules to hide the true cost of these perks from shareholders and the public in general. Don’t like CEOs flying around in private planes? Well that’s just the tip of the iceberg.
Still, it’s not enough to just identify and examine the phenomenon of Wealth Shift. We who have seen it in practice time and time again must work not only to expose it, but also to find a solution for it. The solutions currently being implemented by the vast majority of companies and politicians are twofold. Either we look the other way and chalk Wealth Shift up to a “cost of doing business”, or we heap on even more legalistic policies, procedures, rules and regulations designed to lock the barn door after the cow has already been stolen. This second technique is just as much a failure as the first, however, because it completely underestimates the creativity of the average American. Erect a road block and, in the absence of ethics, we see it as just another move in the game - a challenge to find our way around. No. What we need to do is to make people aware of how destructive their behavior really is and then encourage them to change their focus away from rampant materialism and toward something finer and far more rewarding.
I firmly believe that we Americans are hungry for more. I believe we spend our days scratching, clawing, and compromising our principles to accumulate things because we don't really know what true wealth is and we lack admirable people to emulate. Instead of being solely out for ourselves, we long to be a part of something significant and lasting. We use shopping and other forms of diversion to anesthetize ourselves from feeling the pain associated with an inability to achieve the top two tiers of Maslow's hierarchy of need (namely self-esteem and self-actualization). We go to bed at night feeling isolated from humanity because we spend our lives competing rather than cooperating with each other to achieve life's greatest goals.
In order for change to happen everywhere, we must first make it happen in the workplace. It must start at the top and work its way down. Business leaders must replace their current ideology of “ruin the company, take the money, and run” with a “desire to inspire” and a willingness to create long-lived, purpose-driven organizations that a) encourage their employees to strive to be their best selves, b) compensate them equitably for doing so, c) mentor them in other important aspects of their lives (like debt management and personal financial planning) and d) make them feel like they are participating in something special – something even more important than themselves.
I am not just theorizing here. I have had opportunities to practice what I preach and have experienced amazing results (which I detail in my book). And I am not alone. Bill Cecil of the Biltmore Company, Fisk Johnson of S. C. Johnson and Company, and John Mackey of Whole Foods are prime examples of high-profile CEOs who clearly demonstrate my management philosophy of humanism, mentorship, and legacy building. Indeed, S. C. Johnson and Company not only ranks at the top of Forbes list of Best Places to Work in America, but is also one of the trailblazers in the area of working to diminish the environmental impact of both its production process and its products upon the world. (Not surprisingly, none of these men top Forbes list of highly-compensated CEOs.)
For the first time since the Great Depression our country is in real financial peril. Americans really do want to follow a nobler path, but they need a new breed of business executive to inspire them - one who is willing to set a positive example and prove to his employees that earning a reasonable amount of compensation and building a profitable company with purpose and staying power don’t have to be mutually-exclusive concepts. It is time - past time - for us to rekindle our ethics, reduce the disparity between the have and have-nots in this country, and embrace global humanistic ideals that will restore our standing as the most respected nation in the world. With fear and desperation gripping our nation, I don’t think there is another message out there more important to deliver than this one, and I am asking for your help to spread the Wealth Shift word.
Sincerely,
Dana L. Meador, C.P.A.
http://wealthshift.org/
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