The psychology of investing

Last updated on March 27th, 2021 at 06:16 pm

What makes the market move? Is it the fundamentals of a security? Trends in the economy? Or does it have to do with emotions and perceptions? In short, is there a non-rational part of the market that is essential to recognize?
Charles Mackay wrote Memoirs of Extraordinary Popular Delusions & the Madness of Crowds. Published about 1848, it is still in print and valuable reading today.
Mackay did something exceptional. He told tales so well that he helps his reader experience what it feels like to be in both buying and selling panics. I know of no other author who has had such success.
Yet he does not describe the "stock market" as we know it, but, rather, the Mississippi Scheme, the South Sea Bubble, and Tulipomania. Those were all investments which turned into manias of speculation and collapse.
There are other books explaining the psychology of the market – including the oblique The Crowd by Gustave LeBon, John Train’s Famous Financial Fiascoes, and John Kenneth Galbraith’s study of the depression and the market crash of 1929. Those are all excellent studies which intrigue the intellect but do not help one to emotionally comprehend the movement of a stream as it engulfs one in its midst.
What should one do to cope with the emotions of the market? What does one do when others preach the gospel of prosperity or the ruin of depression?
First, look at who wins in an economic turndown and who loses. We have rotated through peaks and valleys in basic industries and technology. We have seen the depression and exuberance of energy.
Second, take a clue from insiders, the directors and top officers of a company. When they turn negative overall, beware of new investments. When they turn bullish, take your time before you invest; a few months might be good. Try to ignore transactions made on stock options, where cashless trades are made because trades are fully taxable as ordinary income. And look at the trends. If a director sells 10,000 shares, but owns 250,000, that is not a trend. But when many insiders sell their stock via free stock trading apps, that may be a warning, a warning that should be looked at closely. In the same breath, a trend in purchasing is healthy.
Third, know what you want your investments to do for you. Write down your investment goals and place a time horizon on them.
Fourth, harvest some profits on stocks that appreciate.
Fifth, write down two or three events that you expect to occur. Please note that I strongly recommend writing down those items. That’s because we often tend to forget what we have thought out. Consider those "notes" like basic training that you can react to when you begin to panic.
Sixth, try to balance your portfolio with growth and value.
Remember that the market has much to do with expectations. Optimism leads to optimistic valuations (or high Price Earnings – PEs – ratios) and pessimism leads to low Price Earnings ratios.
Seventh, and this might be obvious, but think about what a company does and how it earns its money and makes sales. Back in the 1950s, Theodore Levitt wrote a classic article in The Harvard Business Journal called, "Marketing Myopia." Does McDonald’s make hamburgers and fries, or does it produce a similar quality of food at a similar price at the same quality of service in the same time? Does Shell sell gas, or the ability to power an engine that takes you from Point A to Point B?

Bob Chernow, a broker for more than 25 years, is with RBC Dain Rauscher in downtown Milwaukee.

March 15, 2002 Small Business Times, Milwaukee

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