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Five Ways to Outsmart Other Investors


Why do investors chase hot money and hang on to losers?

Back in mid-June, more than 75% of the investors responding to a CNNMoney poll said they were planning to buy stocks -- many of them aggressively.

Of the 41,572 people polled, it now looks like those 31,179 bullish investors kept their word.

The Standard & Poor's 500 Index has zoomed 15% since those investors were polled (and 53% from its March 9 market bottom).

Let's face it: A 75% bullish inclination is a disproportionately high percentage. It's way out of the norm.

What those 31,179 bulls are telling me is, well, we'd better watch out. Statistically, the individual investor excels at making the wrong decision at precisely the worst possible time. I view this survey as yet more evidence that the "herd" may once again be heading down the wrong path.

After the collapse of Lehman Brothers Holdings Inc, investors yanked more than $120 billion out of equity mutual funds. That's more than the total amount of money investors poured into these funds during 2007 and 2008, a period when exuberance was at its height, according to Money magazine.

And after the S&P 500 hit its March low, most people missed the subsequent rally -- 32% through June 23, when the CNNMoney poll was concluded -- a run-up that could have mitigated their enormous losses.

The disturbing reality is that investors chase hot money and hang on to losers. Most individuals have an awful sense of timing, as well as an unending tendency to act irrationally.

According to a recent Dalbar/IFA study, over-exuberant investors can lose a lot of money. For example, the S&P 500 returned 11.81% a year on average between 1989 and 2008. The "exuberant" gain-chaser scored 4.48% in the same time frame. Factor in inflation and the average investor gain disappears completely, as evidenced in the chart below. You could have done better in a bank savings account!

Hope for the Best, Prepare for the Worst

That brings us back to the two most pressing questions of our time:

1. Whats going to happen next?

2. And what should we do about it?

Although pundits are spewing forth an "improved" outlook for the US economy, history tells us that we're more likely to see a stock-market correction in the near term.

Over the last half a century, stock-market rallies that follow the horrific declines we've seen over the past 24 months are typically followed by a secondary decline of 14% to 50%.

What will happen after that is anybody's guess.

According to a study by Ned Davis Research, any secular bull market that followed a recession in the last 100 years resulted in gains in excess of 60% during an 18-month stretch. In situations where that rally was actually the catalyst for a resurgent economy, stocks averaged 110% over the next 36 months.

But we also have to remember that the bear market that started all this grew out of the worst financial crisis since the Great Depression. According to longtime investor Jeremy Grantham, the record deficits, stimulus packages, and bailout packages have "reduced to guesswork" any market forecasts (as reported in CNNMoney). That's probably why Grantham recently warned clients: "If you feel overconfident about anything, take a cold shower and start [analyzing] again. Just be patient. In our strange markets, you usually don't have to wait too long for something really bizarre to show up."
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No positions in stocks mentioned.
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