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Summary

  • Sentiment (or crowd psychology) is a powerful force in investing.
  • Remember that hogs get slaughtered.
  • Fear can lead to a self-fulfilling correction.

Whether you wish to believe it or not, sentiment (or crowd psychology) is a powerful force in investing. In fact, there is an entire field of finance that studies the emotional biases of investors (behavioral finance).

Hogs Get Slaughtered

People joke (in hindsight, of course) that the Tech Bubble bursting in 2001 should have been easy to foresee, because literally everyone at the time was bragging about making money in stocks. It was a contrarian indicator. For example, when you heard your barber talking about how much money he was making day trading tech stocks...you should have heeded this warning!

This was the epitome of "greed". Everyone (including your barber) thought that investing in stocks was easy money. All you had to do was click "buy".

Well, we all saw how that turned out, When the smoke cleared in 2002, the S&P 500 (NYSEARCA:SPY) was down over 45% from its peak.

What About "Fear"?

"Fear" of losing money is also a powerful force in investing. Now, there are actually two types of fear when it comes to losing money. The first type of fear is the fear of missing out on future gains (which is the first cousin of our friend "greed"). The second type of fear is the fear of losing what you have already gained. In our opinion, this second type of fear is actually more dangerous for the market because it creates an investor with an itchy trigger finger to sell.

My Barber Is Thinking About Selling

We talk to individual investors every day and it's always interesting to hear their perspective on the current state of the market.

That said, a recent conversation with one of our subscribers struck a chord with us. This particular investor was asking us if he should take some profits on some of his winners. Obviously, this is a great question and one that has been increasing in frequency. Stocks are up over 180% from the recent trough in 2009 and the S&P 500 is hovering around all-time highs. Our short answer to this investor was...taking some profits is always a prudent risk management strategy.

The investor's follow-up response was where it got interesting. He went on to say that he was getting his hair cut the other day and he and his barber were discussing the market (as they often do). His barber told him that he was concerned about the market and that he was considering going to all cash.

Talk about sentiment at its best. We got a call from a concerned investor based on what he had been hearing in his network.

Self-Fulfilling Prophecy?

As discussed above, the fear of losing what you have already gained is dangerous...and it can catch on like a wild fire. This type of fear is dangerous because it can turn into a self-fulfilling prophecy for the market. If too many investors are fearful of losing money, they probably won't hesitate to sell at the first indication of weakness...which will exacerbate the selloff.

Should You Heed The Warning and Sell?

We believe that taking profits is always a prudent strategy (in any market environment). We like to buy great stocks at reasonable valuations, so it makes sense to raise some cash at unreasonable valuations.

Raising cash does not mean run out and sell all of your stocks! However, you will certainly need (and want) some cash to take advantage of sale prices in your favorite stocks should a pullback occur.

A critical part of managing a long-term dividend portfolio is establishing (and adhering to) an exit strategy. A proper exit strategy should not only establish a plan to exit a losing trade, but it should also include rules about taking profits on a winner. This doesn't necessarily mean exiting a position completely either. There is nothing wrong with selling 25% or 50% of an investment that has increased significantly in price. Reallocating that capital into an opportunity with a better risk/reward profile is just prudent portfolio management.

So, how much cash should you raise?

The amount of cash you raise will vary by investor, but a good peak cash range to consider is 20%-50% of your total portfolio. Stocks can always go higher, and for that reason, you very rarely should consider moving to 100% cash. For reference, our investment plan is to always be at least 50% vested in stocks (i.e., our maximum cash level is 50% of our total portfolio).

The obvious downside of raising cash by selling stocks is potentially missing out on future gains (and income). Which is a small price to pay, in our opinion...

Conclusion

Investor sentiment is one thing that we like to follow closely. Human emotion is very powerful and it definitely can affect the direction of the market. Is sentiment 100% accurate? No, but investors should certainly not ignore it...especially when your barber says to sell stocks.

Source: The Self-Fulfilling Correction Of 2014?