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Thursday, December 1, 2011

Investors & the Herd Mentality

Many investors react to market conditions like lemmings:

Stampeding up the high mountain when markets are rising and down into the cold deep sea when markets are falling.

This "herd" mentality can be extremely dangerous to your pocket.

Why? Because investors often get into the market too late and get out too early.

You should never let emotions cloud your trading judgment. But you can turn the crowd's fear and greed to your advantage. To exploit market psychology, you must act in a contrarian fashion, taking the contrary course when the crowd falls prey to its emotions.

Extreme optimism can coincide with market tops. People think the sky's the limit and send stock prices flying. Savvier investors sell into this frenzy and run to cash. The market tanks soon afterward.

Extreme pessimism can be bullish. Toward the end of a big decline, the last bulls throw in the towel and sell with a vengeance. Cooler heads smell a fire sale. They dive into the market and buy equities with both hands to launch the next rally.

Studies by economists and psychologists have found that investors are most influenced by recent events -market news, political events, earnings, and so on and ignore long-term investment and economic fundamentals.

Furthermore, if a movement starts in one direction, it tends to pick up more and more investors with time and momentum.

The impact of this lemming like behavior has been made worse in recent years because financial, economic, and other news affecting investor psychology travel faster than ever before.

Capital can also flow now between nations with surprising ease, so that international markets respond more quickly to sudden changes with a domino effect in the direction of investor buying and selling.

How do you stay calm during market drops and restrained during market updrafts?

Here are a few guidelines:

1. Have a plan.

2. Know why you're investing and what you want to accomplish.

3. Pick a strategy and investments that best help you reach your goals.

4. Minimize risks.

5. Don't fall prey to the temptations of greed or fear.

6. Know your investment personality.

7. Pick investment strategies and risks you feel comfortable with.

8. Stick to your investment approach.

If you follow a certain type of investing strategy or a particular investment newsletter, stick with it unless there are sound reasons to change. Different strategies often can end up with similar results over the course of a market cycle. It's the switching back and forth between strategies that can cause problems because jittery investors often abandon a strategy that's temporarily out of favour - just before it makes a strong recovery.

9. Sort out the good from the bad.

Learn to recognize the difference between a poor investment and a solid investment that is having an off period.

10. Diversify.

11. Invest regularly according to your long-term plan &

12. Don't read the daily stock pages.

It's the daily following of the inevitable ups and downs of the market that send the average investors reaching for the phone. Instead, check every two to three months.