Investing can be challenging, not because the concepts are difficult to master, but because we are emotional creatures.

The markets are merely collections of people who act according to their fears and desires of the moment. In 1841, an Englishman named Charles Mackay became interested in the psychological aspects of crowd behavior with respect to people's investment decisions. After analyzing several early widespread financial manias (such as the Dutch Tulipmania and the South Sea Bubble), he wrote a book that has become a classic: Extraordinary Popular Delusions and the Madness of Crowds. When you hear the details of these infamous financial episodes, it's hard to believe that otherwise rational people could get so caught up in a mass delusion. It used to read like ancient history; now it's more like reviewing a stack of recent Wall Street Journals.

Because of human nature and our susceptibility to crowd influences, it isn't unusual for markets and stock prices to become overvalued (or undervalued) from time to time. The graph shows how investors' moods swing in predictable patterns as prices rise and fall. 

1. At a bear market bottom, buying is triggered by an unexpected news event or financial report. The mini-rally is initially met with skepticism and caution.

2. As buying continues, there gradually develops an increasing recognition of positive factors that had previously been ignored. The rush to invest leads to the launch of a new bull market. Confidence returns.

3. As the bull market ages, optimism begins to outpace economic reality. Opinion overwhelms fact. A "buy on dips" mentality develops, reinforcing the uptrend.

4. Euphoria sets in. Negatives are overlooked. There is a growing feeling that the old rules no longer apply. With no fear of loss, greed leads to a kind of buying madness.

5. Buyers become fully invested. The bull market peaks.

 

6. Selling is triggered by an unexpected news event or financial report. The selloff is initially treated as a healthy corrective. 

7. As selling builds, fear and doubt begin to surface. A growing rush to the exits leads to a bear market.

8. As prices continue to fall, pessimism begins to outpace economic reality. Emotion overwhelms fact. A "sell on rallies" mentality develops, reinforcing the downtrend. 

9. Mental depression sets in. Positives are overlooked. There is a growing feeling that the old rules no longer apply.  With no hope of gain, fear leads to a selling panic.

10. Everyone who wants to sell has sold. The bear market hits bottom. 

If you were an active investor in the last half of the 1990s, you saw Stages 2 through 5 unfold before your eyes. Then from 2000-2002 we went through stages 6 though 10.

Those with a short-term focus hesitate to stay invested because they're worried about the curved line. Long-term investors, on the other hand, hesitate to not stay invested because they're aware of the power of the dotted line. Ups and downs come and go, but ultimately, due to the underlying strength of the American economy, we can invest in a diversified portfolio of U.S. companies with confidence.

© Sound Mind Investing

Published since 1990, Sound Mind Investing is America's best-selling financial newsletter written from a biblical perspective.    Visit the Sound Mind Investing website .

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