“You want to be greedy when others are fearful. You want to be fearful when others are greedy. It’s that simple.… ” – Warren Buffett
Investors are emotional and we can profit from it.
Though investors are emotional, they can also manage their emotions to feel the right feeling at the right time.
Market trends are both the result of investor behavior and driven by it. Anyone who watches “the market” has had feelings of fear and greed at some point. Those who “watch it closely” feel it often.
- Fear: I am losing money! Is it ever going to stop?
- Worried: How much more money will I lose?
- Defeated: I’ve lost so much money I don’t know what I’m going to do.
- Hope: I hope I make money this time. I hope it keeps going up!
- Greed: I’m up X%! Up! this, Up! that. I’m up!
- Euphoric: I’m going to tell everyone how much I’m UP! Up, up, and away!
All of these feelings and reactions drive directional price trends. Emotions also determine investor’s results. Investor behavior determines investor’s results as much as their investment program or the market.
Investor sentiment just reached “Extreme Greed” again. Investor sentiment tends to swing from “Fear” to “Greed” a few times a year, mostly reacting to the price trend. That is, we don’t see the majority of investors getting fearful when others are greedy. Instead, we see them get fearful after prices have fallen and they’ve lost some value. We don’t see investors getting greedy after prices fall, we instead see them get greedy after prices have already gained and they are “up”.
Being “up” in a position doesn’t mean anything if it’s “down” in the next period.
Being “up” in a position is an open profit until it’s closed.
An open profit is just the markets money until it’s realized by selling it.
A realized gain is a profit that has been taken by selling.
The Fear & Greed Index I used above is one that is simple to follow for anyone who wants to give themselves a reality check.
If you find yourself feeling euphoric and talking about how great “the market” or your investments are “doing”, this measure is likely dialed to the right for “Extreme Greed”.
If you find yourself fearful of more losses after losses you may be taking too much risk, but it could also be near a turning point. One the one hand, you don’t want to reach your uncle point and tap-out. So, you predefine your tolerance for loss and match that with an investment program that includes risk management and drawdown control.
You want to avoid doing the wrong things at the wrong time- like the quote said.
Although the Fear & Greed Index equally weights seven different sentiment indicators, the most prominent of them is the CBOE Volatility Index® (VIX® Index®), which is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. When the VIX gets really low like it is now, it suggests that expectations for near-term volatility is very low. I say “really low” because, as you can see, its current level of 10.74 is about as low as it’s gotten since introduction in 1993. That’s a contrary indicator because it’s at such an extreme. It seems the market is getting complacent and any surprise will shock them.
What does this mean?
We shouldn’t be surprised to see the recent upward price trend reverse down some, at least temporarily.
And, those who apply the simple sounding strategy of “You want to be greedy when others are fearful. You want to be fearful when others are greedy.” may start to take some profits and preparing to take advantage of, or avoid, a later decline.
It doesn’t mean it will be a large decline, though it could be. For example, the last time I pointed out “Investor Optimism is Reaching Extreme” was December 9th of last year. As you can see below, the stock index dropped only about -2% over the next two weeks. That’s a small drop. Based on history, we expect to see swings of stock index prices of -5% to -10% two or three times a year. When I see such overbought conditions as I see now, I expect that level of normal decline.
The upward trend in U.S. stocks has mostly been uninterrupted since last November. You can probably see how this just adds to the weight of the evidence that we shouldn’t be surprised to see a “normal” drop at some point. As a tactical trader, I prefer to avoid large declines when I can and take advantage of them.
We’ll see how it unfolds this time…
Ps. This is not investment advice and I don’t publish such observations for every swing I see.