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Emotional Strategies In A Bear Market

4 November 2008 No Comment

We all know that emotion drives much stock market activity. For casual investors or new investors, emotions probably drive more decisions than they should. Frankly, it’s extremely hard to remove emotion from investing; but many will agree, the less emotion, the better your investment decisions. Today, I’m going to look at two strategies in the current market that are driven by emotion and why these strategies are not sound investment approaches.

The “Once I Get Back Up To Even, I’m Going To Cash Out” Strategy

Let’s face it. Portfolio performance on the whole are down. Ok, down big. It’s very easy to just wish your positions would go back up to where you bought it and then cash out. It is a common desire for casual investors. There are a few reasons why you should do everything you can to avoid thinking like this.

First, you are too focused on short term valuations. Over the short term, crazy things happen in the stock market. Fear and panic can drive prices down hard over a short period of time like we just saw. Don’t let short term values determine your entire strategy. As you learn to understand trends, you may start to factor in short term prices.

Second, you are too focused on past performance. Basically, you are saying you want to match your past performance except in the opposite direction. The reality is that the stock’s future performance has nothing to do with the past performance. You would be better served to question each position each day as if you had to buy it again. If you can’t make an argument for buying that stock at current levels, you shouldn’t hold it either. Basically, hold or sell the position based on current fundamentals or valuation, not on past performance.

The “I’m Pulling My Money Out And Waiting Until Things Calm Down” Strategy

This is definitely one of the most common emotional decisions during a bear market. People want to cut their losses. They will get back in when things calm down (basically, they’ll get back in when stocks start going higher).

Unfortunately, history tells us that most of the gains are made in the time immediately following a bottom. Usually, we only know this after the fact. Basically, if you wait to get in until after we’ve hit the bottom, you might be buying overpriced stocks already. Even if they aren’t overpriced, you have definitely missed much of the short term gains.

I recommend, instead, doing a re-evaluation of your portfolio. Are there positions in your portfolio that you probably shouldn’t have bought? Perhaps, it’s time to cut your losses there. Are there positions that are just as attractive but selling at a cheaper price? Perhaps, you should load up. Make decisions based on a stock by stock basis not on your entire portfolio.

Conclusion

For all you 20-somethings, don’t fall into one of these strategies.  Instead, use this beating in the stock market as a lesson to make you a better investor.  There will be more bear markets down the road.  What indicators did you miss that you should have maybe scaled back some of your positions before they have gotten chopped in half?  Stay in the game and watch for a bottom.  You probably won’t come close to timing it this time, but maybe you will learn to see how a bottom develops and be able to pick some bottoms in the future.  Again, stay in the game.  Learn from the current environment.  Become a better investor for the long haul!

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