When it comes to the stock market, it often pays to go against the herd and ignore breaking global news. In fact, when most investors let their emotions get the best of them and sell on panic, it's generally a signal to buy, says Richard Peterson, author of "Trading on Sentiment."
What's love (or hate) got to do with it?
Peterson has studied price patterns in the stock market and finds that technical analysis or company fundamentals don't drive the market as much as investors' emotional reaction to global events.
A recent example is the market's immediate downturn the morning news broke about the terrorist attack in Brussels. Typically in situations where investors are reacting to breaking news -- whether good or bad -- the market fluctuates, but then quickly reverts to the mean, sometimes within 24 hours. In other words, stock prices move back to the average price. This was true after the Brussels attack, when the market nearly recovered by the end of the day.
But trying to capitalize on the market by buying on the dip in these situations is tricky and not advisable for the average investor, says Peterson. Traders have algorithms that track market risk in order to take advantage of these emotion-driven peaks and valleys "before the average investor can even blink," he adds.
Although no one can predict how every situation or event will affect the market, there are predictable patterns, Peterson notes. "Ultimately, traders and investors learn the patterns and which events drive which action."
Curb your enthusiasm
Watching and listening to the news is one thing, but it's another to let it govern your investment decisions.
If you can't control global events and how investors will react as a group, you can at least take charge of what you can control: investing in companies with strong fundamentals, or funds that invest in such companies.
"The main thing is to turn off the news and pay attention to fundamentals," says Peterson.
And you can resist the urge to run with the herd and be a contrarian, he adds. For example, during prolonged periods when oil prices are hitting all-time lows, it's a good time to buy, even though many investors are reacting to fear about crude oil prices, driving down the market. You just have to have the patience and the assets to ride out the downturn.
Surprisingly, another contrarian move is to buy companies with solid earnings and a management group that is criticized by the media. Typically, the stock will perform well. Conversely, Peterson says that when a company CEO is featured on the cover of a major magazine like "Fortune," the company stock generally underperforms over the next 3 years.
The best explanation for this seemingly counterintuitive result is that people tend to overvalue or undervalue risk based on emotion, Peterson says. Their feelings about the management drive emotions that cloud their judgment about fundamentals.
Being a contrarian, however, is not easy because you're going against nature. "Buying into the all-good is emotionally the easiest," says Peterson. Instead, try to do what's emotionally difficult. "You want to buy what other people don't want or aren't paying attention to."
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