Investing: from fear to greed

There are a variety of definitions for "bull" and "bear" markets, but the 52.8 percent value lost by U.S. stocks from late 2007 to early 2009 is considered a bear market, and the 267.9 percent increase since then is thought of as a bull market. Beyond the numbers, there are aspects of investor sentiment that characterize bull and bear markets, and understanding how emotions can get the best of investors can help you earn on investments over time.

Fear and greed in financial markets: the past decade

Considering the returns noted above, early 2009 would have been a great opportunity to invest in stocks, but it didn't seem so at the time. During the bear market, investors fled for safety. FDIC-insured banks had their greatest recorded increase in deposits in 2008. One measure of investor sentiment, a ratio of bullish to bearish investors calculated by Yardeni Research, reached one of its lowest points ever late that year. Fear was the emotion of the day.

It's the opposite now. The ratio of bulls to bears peaked around the start of this year. From crypto-currencies to exotic bets on low market volatility, signs of speculation were rampant by the end of 2017. Greed has elbowed fear aside, and is driving investor emotions.

Standing back from those emotions, it doesn't seem logical that investors should have flipped from fear to greed in less than a decade, since stock prices were much cheaper before this bull market. Still, this is the classic pattern over a market cycle - people are most fearful when prices are low, and most confident when prices are high.

Investing rationally

If emotions tend to warp investor reasoning, the best response is to base your decisions on logical principles. The following are some simple, objective principles that should help you make investment decisions logically rather than emotionally:

Understand the fundamentals behind your investments. Don't base your decisions on what's hot and what's not - that can put you in the impossible position of trying to guess what other people are thinking. Instead, the more you know about the fundamentals of your investments, from business plans to valuations, the less you may be influenced by the herd.

Don't be afraid to go against the grain. Popular emotion carries a lot of weight in financial markets. Negative sentiment can keep a market down for a while, just as euphoria can keep a bull market going long past the point of reason. Since you can't guess when the turning point may finally come, you simply need to have courage in your convictions rather than seeking the short-term comfort of running with the crowd.

Keep investing positive cash flow. If you are saving for retirement or otherwise regularly adding to your investments, this is a great weapon to have during a bear market. Due to what's known as dollar-cost averaging, increasing investment as stock prices fall means that the average cost of securities in your portfolio is reduced - something that increases your long-term return.

Rebalance. Don't let your asset allocation stray too far from your long-term targets. In other words, if you've determined that you should be 60 percent invested in stocks, adjust your stock holdings back to this target from time to time. This should keep your risk level in line, and cause you to start to trim stocks as their prices rise, and buy more when they are cheaper. This simple mechanical process should help you buy low and sell high, rather than the other way around.

The volatility experienced by stocks in early 2018 would hardly qualify as a bear market - in fact, stocks are higher now than they were at the start of the year. However, a bear market is likely to come along eventually, and if you don't give into fear when that happens, you may find that bear markets create the best opportunities.

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