An Insight Into The Investor Sentiment Cycle

What to doLegendary investor, Warren Buffett, has always been applauded for his ability to beat the market through his value-investing prowess. So what is his secret?

If you were to ask me, I would attribute his investment success to this famous saying– “Be Fearful When Others Are Greedy and Greedy When Others Are Fearful”.

Yeah, many people may have heard it several times but apparently, they still fall prey to their own human emotions by buying at the peak and selling right at the bottom.

This is often coined as “herd mentality investing”. Let me explain how emotional investing can cost you your hard-earned money if you are not careful.

Stock market goes through cycles just like the 4 seasons: spring, summer, autumn and winter. However, if you were to compare the market cycle and investors’ sentiment, you realise that human emotions often get into the way of investing.

Recovery Phase

During this phase, the market has typically gone through a long bear market and investors have thrown in the towel and given up in disgust. A lot of bargains (attractive valuations) can be found but investors’ “war chest” has been wiped out so it is hard for them to capitalise on the opportunities.

An example might be during the subprime crisis when Straits Times Index (SGX: ^STI) was hovering around 1,600 points and DBS Group (SGX: D05) was selling at $6.90 at its lowest point!

Boom Phase

During this phase, the market is getting more media coverage and more investors are jumping on the bandwagon driven by greed. As a result, trading volumes increase and valuations go up way beyond historical norms.

At the point in time, the fundamentals supporting the bull market are no longer intact. In contrast, it is driven by investor psychology instead. With each profitable trade during the boom period, traders become more confident and put more money back into the markets, not knowing that they have hit the peak of the cycle.

Slowdown Phase

During this phase of the cycle, emotions run wild as investors are struck by fear and re-inspired with hope and greed. The mixed emotions cause markets to be extremely volatile especially with conflicting news where some experts might be calling the market a bubble while others might be telling you that it is an opportunity to buy.

With most companies being predominantly overvalued, a sharp selloff is usually underway. However, most investors who have bought at the top will choose to hold on to their stocks and perhaps average down instead, without realising that the major correction is coming their way.

Recession Phase

The last phase is extremely painful for those who still hold positions. Markets take a real beating at this time and show no signs of letting up. Consequently, investor sentiment changes from denial, to fear, to panic, and to capitulation.

Many investors will hold on to their positions and let go right at the last moment before the recovery. It is often because they have thrown in the towel and lost faith in stocks investment. They chose to bite the bullet and suffer the agony of the loss right when they should be doing the opposite instead.

Foolish Bottom-Line

After understanding the 4 different phases in an investor sentiment cycle, you will come to realise the importance of the saying: “Be Fearful When Others Are Greedy and Greedy When Others Are Fearful”.

As the stock market goes through its cycle, investors ride a rollercoaster of emotions; from excitement to depression. Nevertheless, you can also employ this simple strategy to simply buy into stocks when the market is panicky and selling them when stock prices go through the roof.

In a nutshell, avoid following the herd mentality and practise contrarian investing to model against famous investors like Warren Buffett and Peter Lynch. If they have managed to achieve investment success continuously using this method, so can you.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor James Yeo doesn’t own shares in any companies mentioned.