Emotions Rule the Market...Not Numbers

04/07/2011 10:00 am EST

Focus: STOCKS

Michael Cintolo

Vice President of Investments and Chief Analyst, Cabot Heritage Corporation

In the short run, stocks trade on fears and dreams, not math. And the surest way to lose money is to invest scared, writes Michael Cintolo, editor of Cabot Top Ten Weekly.

I’m going to start with a quote I re-read last weekend from Hedgehogging, one of my favorite investment books. But author Barton Biggs didn’t write the quote; it was actually a passage from another book that Biggs included. Here it is:

“No discussion of the interrelation of stock prices and business conditions would be complete without emphasizing that in the clash of speculative forces on the exchange, the emotions play a part which is not paralleled in the normal process of commerce and industry. The golden mean is non-existent in Wall Street, because the speculative mechanism does all things to excess; even the reactions from the heights of fantasy and from the depths of despair are accompanied by convulsions which are distinct from the calmer tenor of business. Those who seek to relate stock movements to the current statistics of business, or who ignore the strongly imaginative taint of stock operations, or who overlook the technical basis of advances and declines, must meet with disaster, because their judgment is based on the humdrum dimensions of fact and figures in a game which is actually played in a third dimension of the emotions and a fourth dimension of dreams.”
From Ten Years of Wall Street, by Barnie Winkelman

Over the years, I’ve received literally hundreds of questions asking why a stock fell when the earnings report was so good, or why a stock trades at 100 times earnings when there is so much competition, or why the market is going down when corporate earnings are so healthy...you get the idea.

These questions involved dozens of different stocks and many different points in time, but they all have one thing in common; they all relate a stock or the overall market to the “humdrum dimensions of facts and figures”—they are all based on the concept that the market should be highly correlated to real-world measurements like production, output, growth, and earnings.

It Takes More Than Math
“Mike, what are you telling me? That things like production and earnings have nothing to do with stock prices?”

Yes...and no. In the long run, the market is an excellent barometer of the health of the economy—and clearly, earnings are important for stocks.

But it’s really not the earnings themselves—it’s the anticipation of bullish earnings in the future that gets stocks and the market moving higher. (One investor I know uses earnings estimates as his sole fundamental criteria when hunting for stocks.)

The point is that, while the fundamentals of the economy or a stock provide vital background, they are not going to tell you exactly where a stock or market is headed, and when it’s leaving the station. If they did, anyone with good math skills would make millions. Unfortunately, that’s not how the world works.

It’s in the third and fourth dimensions of emotions and dreams that stocks really trade, and the more you keep that in mind, the better you’ll be at avoiding common (but incorrect) assumptions of what drives stocks higher or lower.

Remember that the market is the market, and the economy is the economy—they’re related, but they’re far from the same thing.

NEXT: Can't Stand Losses? It Will Cost You

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Can’t Stand Losses? It Will Cost You
Staying on the general topic of trading psychology, raise your hand if the following has happened to you some time in the past: You buy a stock that’s strong and you’re optimistic it will keep going, but within a day or two, the stock turns tail and falls a few percent. Some analyst cites difficulties at the company.

You panic and sell out to book the small loss...only to see shares move higher in the weeks after your sale, as your original bullish thesis proves correct.

When you do your post-op analysis on this trade, the real reason this investment lost money wasn’t because you picked a bad stock, or even that you bought incorrectly. It’s because you were unwilling to stand any sort of loss in the stock. And I’m here to tell you that the investor who isn’t willing to take some heat is going to lose money in the stock market.

I see this all the time (and, in fact, talked to a couple of subscribers this week about this very subject). The fact is, if you are going to freak out every time a stock goes against you by a couple of points, you’re going to lose a ton of money, because every stock—even a market leader—is going to fluctuate a bit.

So you’ll be repeatedly stopped out, with your portfolio dying the death of a thousand cuts.

Don’t get me wrong—cutting losses short is definitely rule No. 1 when it comes to growth investing. But you also have to be reasonable with your loss limits. Selling every time a stock falls 2% from your buy point is going to create a ton of small losses. Equally important, losing so frequently will seriously mess with your head.

It all boils down to one of my favorite sayings: Don’t invest scared.

While a lot of investors end up losing because they invest with guns blazing (buying huge positions, poor stock picking, disregarding the potential downside, etc.), some also fail because they’re unwilling to lose money. It’s almost like going up to the blackjack table but walking away if the first two hands go against you.

The bottom line is that you should be thinking ahead of time how you’ll handle your stock (“plan your trade and trade your plan”), including when and where you’ll pull the plug. That will keep your emotions from getting the best of you, helping you to hold on to fidgety stocks that go on to become big winners.

This was one of the toughest lessons for me to learn—but once I did, my results improved immediately.

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