Behavioural finance analyst Ken Norquay encourages investors to create an action plan when the market is less emotional than it is now. Create a data-based program that tells you when to buy and sell. Then, simply follow that plan, with no optimism or pessimism.
Because the emotional pitch of the stock market has risen sharply these past few months, we should review the basics of investor psychology.
We all remember that collectively, investors are optimistic at market tops and pessimistic at market bottoms.
The theory of contrary opinion gives us reliable guidelines about buying our stocks ‘when everyone is selling’ and selling our stocks ‘when everyone is buying’. Unfortunately, we investors are not immune to coming under the influence of those optimistic or pessimistic feelings.
Our own human nature makes it difficult for us to objectively assess the mood of other investors. Our own personal attitude and our own personal investment portfolio always cloud our reasoning.
Always remain objective
In my stock market book, Beyond the Bull, I developed a model that helps us remain objective: The Four Ball Model. There are four components of our decision to buy or sell our investments: (1) Intellectual, (2) Emotional, (3) Position, (4) Action.
1. The intellectual component of our decision refers to all the facts and figures that we consider when making our investment decisions. This is the component most widely used by investment salesmen to persuade their clients to buy or sell.
2. The emotional component is about fear of losing money and greed to make more. A long-term bear market is a time when investor mood changes from optimism (greed to make more money) to pessimism (fear of losing money).
3. Position refers to the actual investments you own or do not own. Our self-centred human nature makes us react intellectually and emotionally to our own portfolio’s gains and losses. We do not care so much about the fortunes and misfortunes of others.
4. Action: After these three factors are considered, investors will buy, sell or do nothing.
The key to remaining objective lies in managing our position. If we have a huge portfolio of stocks and the Dow Jones Industrial Index drops 1000 points in a single day, we will feel stress (Emotion). But if we have no stocks on that 1000-point day, we might feel good because a buying opportunity is approaching. Our feelings do not arise from the 1000-point drops; they arise from our investment position. And our feelings, in turn, will determine which facts and figures we will consider in assessing our investments. When we have a lot of cash in a declining market, our objective mind will naturally seek opportunities to buy. If we have a lot of stocks in a declining market, our fearful mind will look for reasons why we shouldn’t worry. That’s why, in long-term bear markets, financial planners and securities salesmen slip into a ‘hand-holding’ mode, reminding us about the long term etc.
Thus, the key to remaining objective lies in our portfolio position. Once we have sold our stocks, we will no longer worry about 1000-point drops in the DJII. If our strategy is ‘buy-low-sell-high’, there is a time to sell out and stop worrying. If our strategy is ‘buy-and-do-nothing-no-matter-what’, then we will have to rely on the ‘don’t worry, be happy’ stories that we will hear during the next year or two.
Let us now review the long-term trends of the financial markets that most affect the well being of Canadian investors.
In the long term . . .
The US Stock Market. The bull market that started March 9, 2009, ended on January 26, 2018. In February, I warned that the US stock market had ‘gone parabolic’ and said: “When it reverses, the steep up trend changes to a down trend quite suddenly. This could happen to the US market in early 2018. Please review your overall investment plan, especially your section on when to sell.” We did not realize at that time that the up-to-down trend reversal had already occurred a few days before our article went to print. The long-term trend of the US stock market is down.
The Canadian Stock Market. The TSX Composite peaked a few weeks earlier in January, and is now in a downtrend. The Toronto market did not ‘go parabolic’ like the US, and therefore may not collapse as dramatically. (Refer to our February 2018 article and to our March 2017 article to read about ‘going parabolic’.) Furthermore, Canadian energy stocks and precious metals stocks have already gone through dramatic declines (energy: June 2014 to January 2016; gold mining: September 2011 to September 2015). There is less risk in the TSX averages than in the NYSE averages. The long-term trend of the Canadian stock market is down.
Long-term interest rates as measured by the yield of treasury bonds maturing in 20+ years are in an up trend in Canada and the US. The down-to-up trend reversal occurred in July 2016, just over 18 months before the final top in the stock market in January of this year. This is significantly longer than the usual six-month lead-time between a bond market top and a stock market top. It testifies to the power of the liquidity-driven bull market that ended so dramatically in January/February.
The US dollar vs. the basket of non-US currencies. The US dollar rose from the financial crisis low of approximately $0.72 in 2008 to the post-election high of $1.03 in Dec 2016. The long-term trend is down.
The Canadian dollar vs. US dollar. The loonie’s long-term up trend is still intact. In the short term, it has been weak since September 2017.
Gold has been in a long-term up trend since December 2015, but the up trend has not been confirmed since the high in July 2016. To confirm the up trend, it needs to break above $1400 US per ounce.
Oil prices have been in an up trend since winter of 2016.
What’s an investor to do?
Having reviewed these financial trends, let us now outline the logical course of action that investors should take. Then we will examine how the optimistic mood of investors at market tops can prevent us from implementing those rational-based decisions.
The US stock market went parabolic after Trump’s election to the presidency. The dramatic reversal has begun. Logically, it is time to sell your stocks and equity mutual funds. The US market is the bellwether for all the stock markets in the world, and it has just reversed from up to down. It has been nine years since the up trend began. Do we think it’s going to go up even further? Even longer? Longer than nine years?! Logically, it is easy to understand why we should just sell our stocks and wait for the bottom in a few years. Why is it so difficult to do this?
In the mood
It’s the overall mood of the investment community. Our greed-mind believes the bullish stock market story, and that story has been true for nine long years. It’s hard to change our mind. What if the market continues to go up and I miss out? That fear of missing out is precisely the mood of optimism that accompanies market tops. That optimistic mood is not logical: it’s emotional, not rational.
Logically, we should be afraid that the market might drop in half as it did in 2007-2009 and 2001-2003. But that’s not how things work in the human mind. In the investment process, we first encounter our mood: fear or greed. That mood directs our mind’s attention to the appropriate data to support it’s feeling about investing.
If we are in the optimistic mood that accompanies market tops (like now), we will pay attention to data that support the bullish stock market story. If we are in a pessimistic mood (like we will be in a few years when the stock market bottoms), we will pay attention to data that support bearish stock market stories. This is how the Theory of Contrary Opinion works. Now is precisely the time to experience that pull of optimism that is so prevalent at tops. That underlying emotional optimism is the reason it is so difficult to sell your stocks now that the US stock market has spiked and reversed. It is that optimism that makes your mind seek out the data that support a more bullish story.
This is why I encourage investors to create their action plan when the market is less emotional. Create a data-based program that tells you when to buy and sell. Then, simply follow that plan, with no optimism or pessimism.
Ken Norquay, CMT, is the author of the book Beyond the Bull, which discusses the impact of your personality on your long-term investments: behavioural finance. He can be reached at firstname.lastname@example.org.
This is an edited version of an article that was originally published for subscribers in the April 2018/First Report of The MoneyLetter. You can profit from the award-winning advice subscribers receive regularly in The MoneyLetter.
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