Investing can be challenging, not because the concepts are difficult to master, but because we are emotional creatures.
The markets are merely collections of people who act according to their fears and desires of the moment. In 1841, an Englishman named Charles Mackay became interested in the psychological aspects of crowd behavior as it relates to people’s investment decisions. After analyzing several early widespread financial manias (such as the Dutch Tulip mania and the South Sea Bubble), he wrote Extraordinary Popular Delusions and the Madness of Crowds.
When you hear the details of these infamous financial episodes, it’s difficult to believe that otherwise rational people could get so caught up in a mass delusion. (For more on the subject: A Short History of Financial Euphoria by John Kenneth Galbraith.) It used to read like ancient history, but many of us witnessed it first-hand in the tech-mania of the late-1990s and the panicked selling during the Global Financial Crisis in 2008.
Because of human nature and our susceptibility to crowd influences, it isn’t unusual for markets and stock prices to become overvalued (or undervalued) from time to time. The graph shows how investors’ moods swing in predictable patterns as prices rise and fall.
At a bear-market bottom, buying is triggered by an unexpected news event or financial report. The mini-rally is initially met with skepticism and caution.
As buying continues, there gradually develops an increasing recognition of positive factors that had previously been ignored. The rush to invest leads to the launch of a new bull market. Confidence returns.
As the bull market ages, optimism begins to outpace economic reality. Opinion overwhelms fact. A “buy on dips” mentality develops, reinforcing the uptrend.
Euphoria sets in. Negatives are overlooked. There is a growing feeling that the old rules no longer apply. With no fear of loss, greed leads to a kind of buying madness.
Buyers become fully invested. The bull market peaks.
Selling is triggered by an unexpected news event or financial report. The selloff initially is treated as a healthy corrective.
As selling builds, fear and doubt begin to surface. A growing rush to the exits leads to a bear market.
As prices continue to fall, pessimism begins to outpace economic reality. Emotion overwhelms fact. A “sell on rallies” mentality develops, reinforcing the downtrend.
Mental depression sets in. Positives are overlooked. With no hope of gain, fear leads to a selling panic.
All who want to sell have sold. The market hits bottom.
Unfortunately, these stages are usually obvious only in hindsight! A month ago, the recent weakness in once-spectacular tech stocks and the unfolding Iran War made it appear that perhaps we were in Stage 6. With April’s powerful market rebound — the strongest since the end of 2008’s Global Financial Crisis — that seems less certain today. It’s typically impossible to know for sure, which is why we don’t spend a lot of time trying to ascertain exactly where markets are along this curve.
The good news is you don’t have to know, as long as you’re utilizing SMI’s strategies. Our toolbox includes defensive approaches such as Dynamic Asset Allocation and the Upgrading 2.0 protocols that (to a degree) will move investors out of harm’s way. If you’re using a blend that includes these strategies, your portfolio will likely be able to navigate storms.
Having your portfolio prepared is only half the battle, however. The other half is preparing yourself emotionally. Investors with a short-term focus are too quick to head for the sidelines because they’re worried about the curved line. Long-term investors have the fortitude to stay committed because they’re aware of the power of the dotted line.
An eventual bear market is inevitable. But those with at least a five-year time horizon can continue investing now with confidence — especially if they’re using SMI’s strategies to do so.
