Market mind games

Are investors falling prey to post-traumatic armageddon hypochondria?

By John Reese Jul 9, 2010 7:09PM

While the economic data that has rolled in over the past couple weeks hasn't been as good as it was a few months back, it's by no means been terrible -- despite what many investors and pundits seem to think.


The manufacturing sector, for example, continues to improve, expanding for the 11th straight month in June (and at a faster rate than it did in any month of 2009), according to the Institute for Supply Management.


Corporate America, meanwhile, is lean and flexible, with nonfinancial firms boasting record cash levels on their balance sheets. And the big banks are in far better shape than they were two years ago.

Nevertheless, investors are running from stocks, pulling billions of dollars out of mutual funds in May and again in June. According to the American Association of Individual Investors' most recent sentiment poll, investors are more pessimistic than they've been since early March 2009.

 

To be sure, there are legitimate concerns about the economy. But it seems investors are focusing only on those concerns while ignoring much of the positive news. Why? Well, according to two top market strategists, it's because recent events have led investors to be quick to succumb to fear. One calls it "battered investor syndrome"; the other refers to it as "post-traumatic armageddon hypochondria." Whatever you call it, it may well be costing you money.

 

"Battered investor syndrome" is what David Dreman, the great contrarian investor (whose writings inspired one of my Guru Strategies) says is occurring. In his latest Forbes column, Dreman explains it this way: "It's a form of slow psychological torture that can eat away at your confidence and your portfolio. There's the PIIGs problem (the fiscal failings of Portugal, Italy, Ireland and Greece), and then there was the mysterious Flash Crash, and now, in a scene reminiscent of A Clockwork Orange, we watch daily videos of oil gushing into the Gulf. It makes you want to just sell stocks and curl up in a fetal position."

 

Dreman says investors should be doing the opposite. "I say it's time to take a deep breath and listen to reason," he writes. The European Union won't collapse, he says, as many of the bigger nation-members have major incentives to keep it together. And he offers reasons battered oil and gas companies represent buying opportunities -- not long-term problems. "As an investor, you need to seize opportunities like the one we have now," he says. "Jittery markets are great for finding bargains if you are a long-term investor."

 

Wells Capital Management Chief Investment Strategist James Paulsen, meanwhile, says the specter of the 2008 crash is driving the current market fears -- post-traumatic armageddon hypochondria, as he called it in an interview with Yahoo! TechTicker. "We take any little data that says the economy is softening and we take it to its extreme, like a hypochondriac would," he said. "It reflects the severity of what we went through [in 2008] more than the reality [of the current situation]."

 

Paulsen says he thinks the current downturn is a correction -- not the start of another bear market.

 

While they use different terms to describe the emotional phenomena they're seeing in the market right now, Dreman and Paulsen are both describing some of the same major behavioral biases that can lead investors astray: "recency bias" (the penchant for investors to assume that the recent past will repeat itself), and "anchoring" (the tendency to base one's decisions on data that is no longer relevant).

 

I see a bit of both of those phenomena in the market right now. These past two months have been the first real adversity investors have faced since the nasty bear market of 2007-2009.


As a result, many are anchoring on the most recent time they faced adversity -- the 2008 crash and its aftermath. They're expecting that the current downturn will turn out the same way -- with initial declines giving way to even more and more declines.


What they're ignoring, I believe, is that the current situation is much different than the situation leading up to the '08 crash. Companies' balance sheets are much better, for one thing. Valuations are more appealing, for another.

 

In the end, the most important lesson is this: Whether you think the economy and market are still on the rebound, or whether you think we're headed for another crash, make sure you base your assessment on facts and figures -- not emotion.

 

John Reese is founder and CEO of Validea.com, a premium investment research site, and Validea Capital Management, a separate account advisory firm. He is author of the new investing book, "The Guru Investor: How to Beat the Market Using History's Best Investment Strategies".

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