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Remember what it felt like to be looking at a 40% loss of capital, perhaps more? Just to remind you, this short article was written at the depths of the stock market slump in 2002.

The next time there is a raging bull market in shares, investors will have forgotten the lessons of the recent share crash and will be rushing to buy whatever it is everyone else is buying. Then, when the bubble bursts, we will see them desperately trying to sell. It is just the nature of investor psychology and while most investors understand that you should buy low and sell high, putting it into practice seems much harder.

The extremes of investor psychology, driven by greed and fear, are most apparent when markets are at their peaks and troughs. At the top of the cycle, investors will convince themselves, on the flimsiest of evidence, that buying a particular security is the right decision. Perhaps you have seen the illustration of investor emotion through the market cycle. It looks like a roller-coaster, with the market first rising steeply and then levelling out before falling steeply and then rising again. The investor emotions trace the rise through optimism to euphoria, and then as the market begins to fall, anxiety sets in, then fear, panic and finally capitulation, before hope and optimism return once again.

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If all investors used a calm, rational, disciplined approach, we would not be in this situation, but sentiment is a part of the emotional response we have to investment. This is nothing new; the book “Extraordinary Popular Delusions and the Madness of Crowds” documents a variety of investor manias going back to the South Sea Bubble and Tulipmania. However, because there are so many millions of Dollars and Pounds and Yen and Euros flowing across the world’s exchanges nowadays, the effect of human emotion and the sentiment of the collective market ( the herd) is much more pervasive in the modern age.

A degree of capitulation is certainly evident from the sentiment expressed by the markets in recent times. We might have reached what the veteran fund manager Sir John Templeton called “the moment of maximum pessimism” which he said was the best time to buy. Will investors be able to shrug off the negative psychology of the bear market and drive stocks back up to more reasonable levels? Experience suggests not. Had they done so in October, they would have experienced one of the strongest growth periods we have seen for some time. Which is why it is important to understand what drives investor psychology, so that we as professionals can try to rise above the herd mentality.

In particular, we need to realise that it pays to be contrarian; that extremes of sentiment, bull or bear, often signal the turning point for markets. For ordinary investors, after more than two years of declining markets, the most important message we can give is that now is not the time to be panicking. That would have been a useful emotion at the top of the market in 1999, but not now. Recent evidence suggests that some investors are realising this is actually a good opportunity to put their money to work, while quality companies are being marked down at record lows.

If you would like to know more, please send me an e-mail.

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