Lifeboat Drills for Stock Market Investors

An excerpt from the seminar "Surviving the Stock Market" by Carol Kean, fee-only investment adviser.

How are your investments affected by emotional vs. rational behavior? That is a real concern for many investors as they analyze the stock market. You must deal with your own emotions as a stock market investor, hanging on as the waves get choppy.

But even as you struggle to maintain control, investor sentiment of others can threaten to capsize your investment boat. You must have solid strategies to avoid being caught up and wiped out by emotional waves.

It's no wonder that investments are controlled to some degree by human emotions. Most often investments are bought and sold under the spell of salesmanship.

As a stockbroker at E.F. Hutton I was taught to promote the sizzle, not the steak. So we stockbrokers came up with sexy stories about stocks to get investors' greed juices flowing. Unfortunately, as a result, most investors had little understanding of the underlying investment, the "steak" they were buying.

Investors didn't know what they were buying, why it went up, and most importantly, why it went down.

Herd mentality also controls investments to some degree.

• In the 1600s in Denmark, tulip bulbs shot from 30 florins to 2,000 florins in only 20 years, with no genuine underlying reasons.
• In the roaring 1920s, everyone, from butcher to baker to candlestick maker, was speculating in the stock market, buying on margin and taking unreasonable risks that fueled a fire that was bound to bum itself out.
• In 1979, we saw the same effect with gold and silver prices, which shot up and just as rapidly fizzled. Why did gold go from $200 to $800 an ounce in just a few months? Herd mentality.

What starts out as a reasonable investment opportunity, given the economic environment at the time, can soon become a free-for-all similar to a soccer game turned into bedlam by crazed fans. When millions buy into an investment just because it is going up, and with no rational understanding of the investment, the inevitable happens.

In the1600s, tulip bulb prices dropped to 300 florins, in 1929 the Dow Jones Industrials fell 50%, and in the 1980s gold settled in at $300 an ounce.

Those who bought early did well, if they sold before reality set in. But the late-corners got caught by what Benjamin Graham, the guru of investing, called the Law of Compensation.

The Law of Compensation says that when an investment is mispriced, usually from fleeting and fickle human emotions, eventually the price will correct, putting a more appropriate price tag on the investment, based on the intrinsic value. Today we have a different term for this: "reality check."

How can you avoid sinking in the rising tide of investor greed? It's really pretty simple:

• Only invest in investments that you understand, and that are worth the money.
• Think rationally and logically, not greedily.
• Understand the forces affecting the economy and investment markets and understand the role investor emotions are playing in valuing various investments. Then diversify to protect against being swamped by the unexpected, so that you minimize the damage of short-term unforeseeable market declines.

Surprisingly, this logical view of investing is called the contrarian approach. It is a rational, don't-pay-more-than-a-reasonable-price approach made famous by super-investors such as Benjamin Graham, Warren Buffet and Peter Lynch. Why is it called "contrarian?" Because it is contrary to buying on emotion, buying what is hot, buying what has a sexy story.

This strategy is also known as value investing. Seek out investments whose prices are close to their true intrinsic values, and not grossly distorted and driven by investor emotion and greed.

This strategy requires patience and conviction. As we have seen, investment prices can be catapulted by emotions. The rational thinker will probably be out of the game by the later stages of an upswing.

But as the Wall Street saying goes, nobody ever got hurt taking a profit. Rational thinkers may miss the upsurge of mass hysteria, but they will be happy that their portfolios are intact when the bubble bursts.

Carol Kean is founder of Sun Valley Financial, a fee-only investment advisory company. You may telephone her at (760) 436-0062.

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