Watch The Pack, But Don't Always Run With It

8/24/2009


I’m sure you know this guy — we all do. I’m talking about the guy who is never satisfied with the hand life deals him, who is always upset about something, and who looks for the worst in everything and everybody.

People who constantly complain or worry can suck the air right out of a room. Follow that trend a bit further, and you’ll find a large crowd of pessimists can suck the life out of the stock market. When bears take the lead, few people enjoy themselves.

Bulls seem to have more fun — and they probably do, when they’re right. Unfortunately, too much optimism can be just as dangerous as too much pessimism.

Following the moods of investors is worthwhile, as sentiment trends can provide valuable insight. But try to keep your emotions in check and avoid getting caught up in the press. With that in mind, here are three important things investors should not do:

Don’t jump to conclusions: One of investors’ biggest frustrations with the Dow Theory is also one of the reasons the Forecasts relies on it. The theory doesn’t attempt to get investors in at the very bottom and out at the very top. And that’s a good thing, because pegging market tops and bottoms is very difficult.

The Dow Theory has been effective for more than 100 years because it requires both a double move (such as a meaningful correction that does not take out earlier lows) and a double confirmation (both the Dow Industrials and the Dow Transports must rebound to reach new highs). Such signals take weeks, and sometimes months, to unfold.

Too many pundits jump in the water before they know whether the tide is coming in or going out. If you don’t guess right, you get mighty cold, mighty fast. Improve your odds by waiting for the market to tell its story.

Don’t fall prey to pessimism. A little skepticism can be a healthy thing — there’s nothing wrong with carrying an umbrella even if it doesn’t look like rain. But pessimists tend to assume the worst and dwell on it. That attitude can hurt more than your investment returns. In studies published in 2000 and 2002, the Mayo Clinic found that optimists tend to live longer than pessimists and have a better quality of life. A study released this month found that optimists were less likely to suffer from heart ailments.

Pragmatists follow billionaire investor Warren Buffett’s Noah rule: “Predicting rain doesn’t count; building arks does.” Prepare for rough times by boosting your cash position and taking a defensive tack with your portfolio, but don’t give up on stocks.

Some pessimists take such preparedness too far, selling out of the market entirely. Such a strategy could prove hazardous to both your health and your wealth.

Don’t blindly follow even the best advice. Over the years, I’ve talked to many investors who simply didn’t trust one or two of the stocks we recommend. They were too small, too risky, too obscure, etc. While we may rate a stock a Buy because we think it has excellent total-return potential, no stock is worth losing sleep over.

Don’t get me wrong — the Forecasts recommends that every investor who owns stocks should build a diversified portfolio, including both large and small stocks. Diversification reduces volatility, and a few stocks that appear risky on their own can boost return potential without adding much volatility to a portfolio. But if one of your stocks regularly causes you to chew your fingernails to the bone, consider dumping it if you can find something of similar potential that won’t worry you so much.


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