One of the more revealing areas of behavioral economics is how investor sentiment affects financial outcomes. Economists once sought to understand financial markets by studying them dispassionately, but behavioral economists find that investor sentiment significantly accounts for stock market movement. This is particularly evident at the end of an expanding bull market. Observing typical investor behavior at this critical moment may suggest better ways of participating in the market as it drops.
The Bull Market Recovery
The average investor misses out on the bull market -- often because he suffered substantial losses in the previous bear market and stays out of the recovering market until well into the recovery, when he cautiously begins investing again. At first, he invests in relatively safe value stocks -- stocks with low P/Es (price-to-earnings ratios) and other indications of hidden value. As market momentum builds, the average investor, now making money and feeling exuberant, begins moving out of value stocks into more glamorous growth stocks -- stocks with above average growth in earnings, sales and cash flow and higher than average P/Es.
The Rest of the Story
Eventually, the bull market peaks and begins cooling off. When prices fall, growth stocks suffer most. The average investor, now heavily invested in growth, sticks it out until the losses become too painful to bear, when she capitulates and sells out. Most economists agree that the moment of capitulation signals the market bottom. Our average investor is now out of the market and in cash as the market cycle turns toward recovery. She waits too long, then begins investing again, cautiously at first, then with increasing confidence as the bull market peaks. The story of the average investor is a cycle that always returns to the beginning.
The Lesson Learned
Economists generally agree that early in bull markets, riskier seeming growth stocks outperform value stocks. Later in the cycle, and especially late in a bull market, value stocks do better. The average investor stays out of the market at the beginning of the recovery, when the best performance comes from investing early, then buys value stocks when growth stocks perform better, switching to growth stocks in time to watch them fall proportionately further than value stocks. This is how the average investor significantly underperforms benchmarks like the S&P 500.
What to Do Instead
Several highly successful investors, Warren Buffett among them, recommend investing in value stocks generally. Considerable research evidence suggests that, over the long run, value stocks do better than growth stocks. You don't need to avoid growth stocks entirely, but at the peak of the bull market, consider beginning the switch into value stocks. When the bull market ends -- usually in an atmosphere of high volatility and periodic, frightening downdrafts in the S&P 500 -- you do nothing. You're already in value stocks, which suffer less in bear markets. You lose some of the money you've made but less than the average investor. Long before the average investor dares to invest again -- early in the next bull market's beginnings -- you move from value stocks to growth stocks and follow the cycle again.
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