Investors are breathing a sigh of relief. The devastation of the stock market drop has been assuaged by the bear market rally of the last 7 months. The Dow reached the magical 10,000 level recently. Some of the losses are recovered. What is an investor to do now?
The easiest approach an investor can take is to follow the crowd. The last 10-15 years exhibited a great deal of crowd following. Many invested in particular stocks or perhaps the market in general (mutual funds) since their brokers told them to or their friends/family suggested it. Crowd investing is a very powerful force. Once someone else has success in the market your instinct is to follow. “Rational” approaches to market investing certainly were not in vogue in the late 1990s. How 
do we know this? If stock markets always followed a “rational” approach, the prices of some technology stocks would never have reached the lofty heights experienced in the late 1990s to 2000 (remember the Tech Bubble?). Rational methods of stock evaluation, like the price/earnings ratio, yield, or book value would have alerted a “rational” investor that the price of these stocks was not rational. As a justification for the inflated prices, a new paradigm emerged such as “this is a new era of investing” or the term “New Economy” was proposed. These justifications were necessary in order to override “rational” stock valuation methods. Some technology company market values (stock price multiplied by outstanding stock issued) were recognizably inflated. Nevertheless, it did not matter since people were making money (on paper). In our present bear market rally, some of the leaders (AIG, Fannie Mae, CIT) are companies with negative earnings!
When I asked investors their exit strategy with stock investments, people offered a blank look. In other words, at what price level would a person sell their stock and take their profit? For most stock investors, the idea of taking a profit is not in their thought process. Will your profits always be “on paper”? Do you know when to take a profit? Our first law of investing follows.
The most difficult aspect of stock investing, and perhaps investing in general, is to know when to take a loss. Take a loss? Most investors have no plan to exit a stock after it experiences losses. The most common response is to buy and hold since the market always “comes back.” During the Great Depression, the top of the market occurred in 1929 and the bottom came in 1932. For those stocks that remained, some lost 90% of their value. The top of 1929 stood for another 25 years.
The average investor experienced an amusement park ride starting in 1929. First the value of the stock portfolio plummeted by 85% in 3 years. While some might declare the bear market over in 1932, the stock values witnessed in 1929 stood until 1954. How did “buy and hold” feel for those investors? Would you feel comfortable seeing stocks behave in the same manner for a 25-year period?
Fidelity Investments is a custodian for 401(k) accounts. They reported very little 
movement out of stocks (“hold”) this past spring despite significant losses in the value of the public’s 401(k) accounts. We can conclude there was still a level of confidence with 401(k) investors; otherwise, there would have been a massive stampede out of stocks. The public felt the market “will come back” and to an extent it has. The public, however, has no exit strategy. Another psychological characteristic fueling the lack of an exit strategy is that most investors or advisors have never experienced anything but a rising market. Thus, they have no time horizon to have witnessed a market behaving otherwise.
The psychology of not knowing when to take a loss is akin to a gambler who loses money at the table and continues to bet. In fact, the bets may increase in scope in the hope of winning back the earlier losses. Some contemporary financial advisors or pundits advocate purchasing stocks now that they are “cheap”. The musician Kenny Rogers sang, “You gotta to know when to hold up. Know when to fold up. Know when to walk away. And know when to run.” These words give rise to the second investment law:
Jim Mosquera is the author of The Sentinel Economic and Financial Newsletter