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Do You Run With the Stock Market Herd?

May 12, 2008
Finally you have some extra money that you can call your own above that required for living expenses. Your extra money is true risk capital as you could lose it and not have to adjust your lifestyle.

Naturally, you want to see your extra money grow.

At today's low rates of interest saving your money in a bank doesn't entice you as it offers too little growth potential. The interest return is even below the inflation rate so you are a sure loser. You want something that gives a little more risk, with the hopes of having a much larger financial return. You turn to the stock market.

But wait! Are the risks involved in investing in the stock market worth the potential returns? Investing is a good tool to increase you money, but you have to keep an open mind and know what to look for.

Investing in stocks is a more risky business than many investors realize. However, there are some risks that fortunately, you can control.

For example, you must guard against investing in "hot" stocks that have already had a big run up in price level. True, some investors became wealthy by investing in "hot" stocks such as the "dot-com" bubble in the 1990s. Those who sold out near the highs, that is.

When the initial buzz around "hot" stocks begin to slide, so does the value of your investment. And fast. Don't forget the idea is to buy low and sell high, not to buy high and hope that an army of fools come along to buy even higher.

Once they fall, the "hot" stocks really fall hard in a short period of time. This means losing a big chunk of your money as will others like you who invested in these stocks. If you really need to invest in these stocks, you have to keep a constant eye on them and sell them when they start to level off or drop below a certain level.

To avoid such risks, some say that you should diversify your portfolio. But not too much if your funds are limited. Basically, to diversity means buying a little bit of several different types of stocks. In that way, if one stock gets down, another one of your stocks might be up and will help you recover your losses.

It is a good idea to have some stocks in different sectors, such as the technology sector, financial, telecommunications, biomedical, and consumer corporations. In time, you could add to your portfolio with precious metal and diamond indexes, and some general investment funds.

Another school of thought says it is better to have a highly selected basket of growth stocks and then to watch that basket like a hawk. Personally I think that this approach makes more sense, especially if you are starting out with limited funds, as a broad portfolio of stocks in many different sectors will tend to track the overall market, not out perform it.

In addition, there are companies that offer "safety stocks". It may be a sound decision to have shares of companies such as this in your portfolio. This is because such stocks most often offer a slow and steady growth, thus giving you an assurance of being profitable over the long term with your investments.

Do not rely on tips saying that this stock is "going to be big" and the like. These tips are often unfounded, and these stocks are almost always totally manipulated. Investing in these stocks might give you a higher short term return but in the long run, these stocks will just give you worries. Check relevant websites to see how your stocks are performing.

Investing in stocks can be very profitable but you do have to work at it to stay on top of the stock market. The best stock investments of all are those that are made after a bear market has run it's course. Then you can invest in top flight companies whose shares have reached very cheap prices after being dragged down by the bear market.

PE ratios at the bottom of bear markets usually reach levels of 5 or 6. Compare that to the present PE ratio of about 20 and you can see that today stocks are not cheap.

Unfortunately, most investors can not bring themselves to buy at extreme lows as market sentiment at that time is completely negative and most people have a herd instinct that they can not overcome. When running with the herd fear overcomes judgement and they are much more likely to be sellers at important lows rather being able to overcome their fear and to be buyers.

The same type of problem occurs with the herd at market tops. Then the herd is so optimistic about the outlook for the stock market that they forget about prudent evaluations of a stock and will pay almost any price to get on board.

To be a successful stock investor you must be able to think for yourself and cut away from the herd mentality. You also need a lot of discipline so that you can patiently wait for good stocks to reach extremely attractive price levels before adding them to your portfolio. When you buy shares in good solid companies at cheap prices over time good things are going to happen to the value of your portfolio.
About the Author
Gerald "Taipan" Greene is a retired forex trader and portfolio manager who worked in Asia for over 20 years. The nickname was acquired in Hong Kong and is now used for a number of financial related blogs. One of them is at Stock Market Pro
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