It’s always worth revisiting the 10 Rules for Investing by Bob Farrell, the legendary former head of research at Merrill Lynch.
It’s especially timely when the major stock indices and many other indicators are breaking many of his rules unlike the Merrill Lynch bull not breaking China in that commercial years ago.
We hi-light Rule 5 and a telling chart which relates to retail investors or the general public or, as many call it, the dumb money. The more there is, the worse it gets. Here’s why.
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by Michael Leibovitz, Real Investment Advice
Rule #5: The public buys the most at the top and the least at the bottom.
Like it or not, retail investors, aka the public, are often called dumb money. Take it for what it’s worth, as the saying was made by professionals or so-called smart money.
Bob’s rule is logical as the public is usually more susceptible to psychological factors. Greed often gets the best of us. Think about how hard it is to sell a stock when it’s up 50%.
At such times, investors are loathe to sell it because greed accentuates our FOMO (fear of missing out) on additional profits.
Smart money is equally susceptible to greed, but they often have risk management guidelines that limit their risk-taking ability.
Fear works similarly. An adage on Wall Street says investors are the only type of consumers that do not want to buy when prices go on sale.
The fear of even lower prices is powerful, especially in larger routs when valuations make sense again.
Currently, retail investors are having a field day. Per JP Morgan, courtesy of Zero Hedge:
“The estimated retail investor net flow into US equities and ETFs from this methodology has been hovering at a very high $700mn per day pace in recent weeks (including the week ending July 30th). As a result, the monthly net flow for the month of July rose to a new record high of $15bn, surpassing the previous record high of $10bn in June by 50%!”
The graph below shows the public has more invested in this market than any time in at least 70 years!
Here are Farrell’s 10 Rules for Investing, courtesy of Investopedia:
1. Markets Return to the Mean Over Time
Whether they face extreme optimism or pessimism, markets eventually revert to saner, long-term valuation levels.
According to this theory, returns and prices will go back to whence they came—reversion generally puts the market back to a previous state.
So when it comes to individual investors, the lesson is clear: Make a plan and stick to it. Try to weigh out the importance of everything else that’s going on around you and use your best judgment.
Don’t get thrown by the daily chatter and turmoil of the marketplace.
2. Excess Leads to an Opposite Excess
Like a swerving automobile driven by an inexperienced youth, we can expect overcorrection when markets overshoot.
Remember, a correction is represented by a move of more than 10% of an asset’s peak price, so an overcorrection can mean bigger movements.
During a market crash, investors are presented with really great buying opportunities. But they tend overcorrect in either direction—upward or downward—and trading can happen at unbelievable levels.
Tuned-in investors will be wary of this and will possess the patience and know-how to take measured action to safeguard their capital.
3. Excesses Are Never Permanent
The tendency among even the most successful investors is to believe that when things are moving in their favor, profits are limitless.
That’s just not true, and nothing lasts forever—especially in the financial world. Whether you’re riding market lows which represent buying opportunities, or soaring at highs so they can make money by selling, don’t count your chickens before they’ve all hatched.
After all, you may have to make a move at some point, because as the first two rules indicate, markets revert to the mean. Markets always revert to the mean.
4. Market Corrections Don’t Go Sideways
Sharply moving markets tend to correct sharply, which can prevent investors from contemplating their next move in tranquility.
The lesson here is to be decisive in trading fast-moving markets and to place stops on your trades to avoid emotional responses.
Stop orders help traders in two ways when asset prices move beyond a particular point. By determining a specific entry or exit point, they can help investors limit the amount of money they lose, or help them lock in a profit when prices swing in either direction.
5. Public Buys Most at the Top and Least at the Bottom
The typical investor reads the latest news on their mobile phone, watches market programs, and believes what they’re told.
Unfortunately, by the time the financial press gets around to reporting a given price move, that move is already complete and a reversion is usually in progress.
This is precisely the moment when John Q decides to buy at the top or sell at the bottom. The need to be a contrarian is underlined by this rule.
Independent thinking always outperforms the herd mentality.
6. Fear and Greed: Stronger Than Long-Term Resolve
Basic human emotion is perhaps the greatest enemy of successful investing. But whether you’re a long-term investor or a day trader, a disciplined approach to trading is key to profits.
You must have a trading plan with every trade. You must know exactly at what level you are a seller of your stock—on the upside and the down.
Knowing when to get out of a trade is far more difficult than knowing when to get in.
Knowing when to take a profit or cut a loss is very easy to figure in the abstract, but when you’re holding a security that’s on a quick move, fear and greed act quickly to separate you from reality and your money.
7. Markets: Strong When Broad, Weak When Narrow
While there’s much to be gained from a focus on popular index averages, the strength of a market move is determined by the underlying strength of the market as a whole.
So broader averages offer a better take on the strength of the market. That’s why it can pay off to follow different indexes—at least those that are beyond the usual suspects like the S&P 500.
Consider watching the Wilshire 5000 index or some of the Russell indexes to get a better appreciation of the health of any market move.
The Wilshire 5000 index is composed of nearly 4,000 U.S-based companies that are traded on an American exchange and whose pricing is available to the public.
Russell indexes like the Russell 1000 and Russell 3000 are weighted by market cap and also give investors exposure to the U.S. stock market.
8. Bear Markets Have Three Stages
Market technicians find common patterns in both bull and bear market action. The typical bear pattern, as described here, first involves a sharp sell-off.
During a bear market, prices tend to drop 20% or more. In most cases, bear markets involve whole indexes. This kind of market is generally caused by weak or slowing economic activity.
This is followed by what’s called a sucker’s rally. Investors can be drawn into the market by prices that jump quickly before making a sharp correction to the downside again.
These rallies, which can be a result of speculation and hype, don’t last very long. But who are the suckers? The investors, of course.
They’re called suckers because they may buy on the temporary highs, but end up losing money when asset prices drop.
The final stage of the bear market is the torturous grind down to levels where valuations are more reasonable and a general state of depression prevails regarding investments overall.
9. Be Mindful of Experts and Forecasts
This is not magic. When everyone who wants to buy has bought, there are no more buyers. At this point, the market must turn lower.
Similarly, when everyone who wants to sell has sold, no more sellers remain.
So when market experts and the forecasts are telling you to sell, sell, sell—or buy, buy, buy—be sure to know that everyone is jumping on that bandwagon, so much so that there’s nothing left to sell or buy.
By the point you jump in, something else is likely to happen.
10. Bull Markets Are More Fun Than Bear Markets
This is true for most investors since prices continue to rise during these periods. Who doesn’t love seeing their profits rise? Well, unless you’re a short seller.
A short sale is when you sell an asset that you don’t own yourself. Traders who use this strategy sell borrowed securities hoping the price will drop.
The seller must then return an equal amount of shares in the future.
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