Making smart investing choices is the key to making a profit and avoiding losses. But, how do you make smart choices? What analysts do you listen to and when do you follow the herd versus being a contrarian? There are signals that seem to occur in every market situation. But, why do signals help you make smart investing choices?
Avoiding the Twin Demons of Fear and Greed
When the value of an investment, like a stock, is going up, it is easy to become greedy. And, when the value of that investment starts to fall, it is easier to become fearful. These traits are not limited to you, Ms. or Mr. Investor. They tend to be shared by the majority of investors. Successful long term investors have gone through many business cycles and have come to recognize some basic signals. None other than Warren Buffett has advised investors to be fearful when others are greedy as noted in an article by Investopedia.
Warren Buffett once said that as an investor, it is wise to be “Fearful when others are greedy and greedy when others are fearful.” This statement is somewhat of a contrarian view on stock markets and relates directly to the price of an asset: when others are greedy, prices typically boil over, and one should be cautious lest they overpay for an asset that subsequently leads to anemic returns. When others are fearful, it may present a good value buying opportunity.
The problem with applying this adage is market timing. For example, stocks have been on their way up for years. It is true that the S&P 500 is down on the day, week, and month. And it is unchanged from its value at the beginning of the year. But it is nicely up over 5 years and hugely up over ten years. In this regard, why do signals help you make smart investing choices? One good reason is that they help you avoid letting fear and greed drive your investing decisions.
The Market Follow-through
The stock market seems to be correcting, driven by a too-strong dollar, what is shaping up to be a permanent trade war, and the Trump tax cut stimulus wearing off. As such, many investors are adjusting their portfolios as witnessed by a flight to quality investments.
Each investment niche goes through cycles whether it is agricultural commodities, stocks, gold, or real estate. Basically, many investors think that the stock cycle is turning and they are hedging their bets, based on fundamental factors such as the trade war, tax cuts wearing off, higher interest rates and the dollar, and the risk of a global slowdown. But, remember that all investors are subject to the twin risks of fear and greed!
In regard to make smart investing decisions before and after a correction, we looked at an article in Investor’s Business Daily and a signal called the stock market follow-through.
The follow-through is a simple concept. It involves a significant gain in higher volume in the Nasdaq or S&P 500. After a serious correction on Wall Street, most follow-through days occur at least four days into a new rally attempt. IBD’s The Big Picture column flags these critical market turns. When it takes place, investors should actively search for leading stocks that break out from sound bases.
What these folks are talking about are opportunities to profit after stocks correct and before another rally takes place. (They also note that the signal is not infallible.) Nevertheless, it is a useful tool, but with it and others, why do signals help you make smart investing choices?
History Repeats Itself
The use of predictive tools to guide buying and selling in markets goes back a long way. Japanese rice traders in the times of the Samurai were using a tool they called a “candlestick” as a visual guide to trading, and predicting price movement in the rice market. Interestingly, a “bearish reversal pattern” in Japanese Candlesticks requires a follow-up confirmation day, just like the stock market follow-through. Both of these happen as a downward trend (bear market) starts to reverse, and both, when used correctly, can lead to impressive gains as the market or an individual stock heads back up.
How is it that both a modern “trading signal” and one that dates back to when there were still Samurai running Japan seem to be picking up on the same market movements? Technical trading signals are developed by looking at repeated market events and identifying similar pricing patterns that evolve in similar circumstances. We can assume that human emotions were the same for rice traders back in the days of the Samurai as they are today for those investing in and trading stocks. It would appear that the sum total of human emotions and human actions tend to reliably generate similar patterns in similar market situations. If you believe that history can repeat itself, perhaps you can benefit from some of these signals when this market corrects and then recovers.