Investment pros are profiting from your panic

September 23, 2011

Don’t take this the wrong way, but everything you’re thinking and feeling about the stock market is usually dead wrong. And money managers appreciate that. Your missteps often help them profit.

It’s a basic premise of behavioral finance, that folks behave irrationally when it comes to their investments. People are panicking like the world is coming to an end? Time to buy. Your cabbie is giving you stock tips during a raging bull run? Time to sell.

Enter the investor sentiment reading.  A few key metrics – like the American Association of Individual Investors Index, the Consensus Index, and Market Vane – track what you and I are feeling about the stock market, and convert it into numbers. For true contrarians, the findings are just as telling as more fundamental metrics like price/earnings or free cash flow. For example, if Mom and Pop investors are overly bullish or bearish, then it’s a flashing billboard to go the other way.

“It’s the perfect contrary indicator, and has been for a long time,” says Keith Springer, president of Springer Financial Advisors in Sacramento, California and author of  “Facing Goliath: How to Triumph in the Dangerous Market Ahead.”

“The public is always wrong. They always act on emotion – to buy when they feel the best,  to sell when they feel the worst,” he says.

And right now, they’re feeling pretty darn glum. The AAII index is currently at 30.5 percent bulls, virtually unchanged from the week before. Once it’s below 30 percent, Springer starts getting an itchy trigger finger to buy equities. Spurred by Thursday’s massive selloff, with the Dow dropping a few hundred points to well below 11,000, we could see those numbers dip even further. And if it craters below 20 percent? A “screaming buy,” Springer says.

Sentiment readings aren’t that radical a concept. In fact, they can trace their lineage to the original value investor, Ben Graham, who famously held that Mr. Market is a fickle and irrational beast. He quotes different stock prices virtually every second, based on the whims of the moment, and smart investors can examine company fundamentals to identify seriously mispriced equities.

Nevertheless, many market watchers don’t even know what the AAII number even is. “I love the fact that nobody ever talks about it,” says Springer. “Because if everyone followed it, then it would become worthless.”

Of course, investor sentiment isn’t exactly a slam-dunk metric. If it were, then everyone would be filthy rich already. Tread especially carefully if speculating in embattled individual stocks. Sentiment readings won’t be of much help if – as with BNP Paribas, say – you’re stepping in front of a speeding train. That said, a few pointers for leveraging investor sentiment to your best advantage:

Look for longer-term trends
A one-week blip, of an unusually high bullish or bearish numbers, shouldn’t be enough to start moving money. Once you’re hitting three or four weeks of persistent numbers, that’s the real tipoff that investors are feeling overly doomed or elated.

Realize their limitations
The AAII reading isn’t a truly scientific result, in that it’s a voluntary member survey. “While the organization has 150,000 members, we understand that only several hundred regularly participate,” stock-market research firm Birinyi Associates points out in a recent research note. As the product of a self-selecting process (like political exit polls), the data is useful for understanding broad-strokes trends but shouldn’t be taken as absolute gospel.

Weigh readings from multiple sources
Since survey samples can be relatively small, it’s possible a particular metric could get a one-week reading that’s out of line with popular sentiment. For a better bird’s-eye view, scour a variety of polls (check out a handful of the most prominent ones here.) “Sometimes the readings are not all the same,” says Paul Azzopardi, the Toronto-based author of Behavioral Technical Analysis. “You’re looking for extreme values from multiple indicators, because after that, sentiment usually changes – and the market changes along with it.”

Don’t expect immediate results
If you buy after a period of extreme bearishness, and don’t realize quick profits, don’t despair. This is a longer-term tool, not something for the day-trading set. “The stock market doesn’t turn on a dime,” says Springer, who expects the AAII number might dip to 25 percent bulls after this particularly bumpy week. “But it could suggest that we’re within range of a sizable rally.”

5 comments

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Ok I get the point – but it has to be said, these so called financial gurus, have completely got it wrong and this is why shed loads of cash has been lost. Please don’t bother defending the action of bankers as no one believes you !

Posted by Pedrolondon | Report as abusive

I’m a AAII member. I never, repeat, never respond to the sentiment survey. I also think that there are investors who will intentionally respond in a manner contrary to their real opinion, just to try to skew the market. The sentiment readings, as an indicator, are well known. AAII members, that I’ve met, are sharp and know this old saw about going contrary to the survey. I wouldn’t count on it. The “public” is no longer investing in the market and that should be common knowledge by now. What about the reporter… are they of the mind that “ma and pa are out there investing”? Give us a break.

Posted by Teachertaughter | Report as abusive

How much of this turmoil in the financial markets has been manufactured in order profit from the emotional response of investors?

Yesterday on the radio, there was talk about the Euro crisis possibly forcing Greece to accept government by the European Union. For those who have read Naomi Klein’s “Shock Doctrine”, this suggestion is pretty scary.

Always remember the Japanese concept of fascade (“omote”) and the real, behind-the-scenes reason (“ura”).

Posted by realmotive | Report as abusive

The idea of irrational behavior is central to our approach at Betterment.com. We’ve seen time and time again that even the most knowledgable people are subject to overconfidence bias and make decisions that don’t serve them well. Additionally, we choose the path of least resistance and forget to do things that do serve us well (like rebalancing our portfolios). Our investing platform works to overcome these barriers. Thanks for the article Chris.
– Johanna

Posted by JohannaScott | Report as abusive

I disagree. It’s all the major hedge funds, mutual funds, speculators and currency traders. The yen is going up because traders borrowed them and now need to pay them. So all the assets they bought overseas are being liquidated. The yen carry trade still unwinding. Then we have speculators that used margins force to liquidate their trades. Then we have the shorts tanking the market. All feeding on itself. It has very little to do with mom and pops and joe and jane.

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