The Psychology of Losing - Explaining Investors' Bear Market Behaviors

Confession time. This is the first bear market I understand as a loser. Imagine that. I was in Magellan Fund when Peter Lynch ran it. I write newsletters, for heaven's sake. I have a record of finding great stocks before they get hot. And I've seen plenty of bear markets before this one. And for the first time ever, I open my account and feel like a loser.True, only one position bugs me. But it is the single investment that may be most like the investments thousands of people make. It's become an amazing window into how a "market" thinks.I bought the losing stock because someone I trust told me about it (you know who you are, love of my life). This is someone with a record of finding phenomenal global stocks that go up hundreds of percents … an expert in Asia. But the buzz led him to this little penny stock that was supposedly capturing attention.First mistake - I don't buy penny stocks. They're OK for those who enjoy wild-eyed speculation based on what they think other people are doing. But they don't fit my long-term value profile. Or even my "reasoned and disciplined speculation on major stocks for good reason" profile. I shouldn't have done it. I don't know beans about penny stocks. Second mistake - I did no research of my own. Not even checking to see if I liked what the company had done so far, what it made or sold, or even what its plans were. Stupid, stupid, stupid. Did I mention that was really dumb of me?Third mistake -I had no reason for investing. "Because someone said it's going to go up" does not count. There has to be a cause. It's going to go up because … pick one: sales are rising, a new contract is a big deal, the new product will grab market share, margins are improving, or even there's momentum, which I can see because MACD just crossed positive and the stock had a point-and-figure triple-top breakout. Even speculations need some facts underfoot. Refer to Chart_3.jpgThe other 99 percent of my positions are terrific. That includes those that are down recently, because their short–term price action doesn't alarm me. They are great companies in a bad market. Big deal. I wasn't planning on selling them this year, anyway. So I feel good about their long-term outlooks, and their recent business performance backs up everything I believe. But this one stock has taught me how it feels to invest not knowing enough. Millions of investors are in my shoes. They bought something because their broker had it on the hot list to push, because they read a magazine article about it, because Yahoo! Finance keeps pushing it, or because someone they know recommended it. The most enlightening thing about this is that suddenly I really understand all those technical patterns that happen in a bear market or in a single stock that has plunged. In theory, I know stocks that come off their bottoms have setbacks. This is the first time I've found myself thinking in ways that would cause such a thing. I'm down so much that when the stock came up a couple of pennies, I thought maybe I should sell and take what gains there are. That is exactly what happens in a bear market when stocks hit their final (or significant) bottoms and begin to rise. Millions of people are watching, and at least some of them think, "at last, I get a little more than I had last week, better take it now." Then the rising stock falls again. But if the bottom really was the bottom, then before the stock hits it or gets close, it begins another rise. This time, it may go past its recent sell-off spot because those people already got out. This time, if you look at a chart with volume-by-price bars along the side, you can almost guess where another sell-off is going to happen - at the spot where the largest blocks of buying occurred before the bottom. At that point, millions are watching and some of them are thinking, "thank gosh I'm back to even, and I've had enough pain. I'm getting out." Similar reactions happen when stocks get to old support areas, which are spots the stock kept falling to, but not through, for a long time. Sell-offs of rising bear-market stocks also occur where very large and sudden drops happened in the past. In all these cases, the mental tape is the same, "I'm finally better off than I was, and this stock still scares me. I'm outta here before it goes down again." The chart for Sears Holdings (not the stock I bought) shows how that works.You notice that none of those reactions has a single thing to do with the company itself. Not its earnings, its prospects, its competitors, its discoveries, its patents, its contracts, or its market conditions. Nothing. When it comes to a loser like the one that's bugging me, it makes sense to sell out at any of the emotional points. Or at least it makes more sense than it did for me to buy the fool thing in the first place.But for most of your stocks - which I hope are like most of my stocks - a different bear market strategy is in order. You should acknowledge that the selling on the way up from a bottom is not necessarily a sign that anyone knows something you don't. Most likely, it is caused exactly by people who don't know nearly as much as they should - people who are easing their emotional pain, not behaving in any rational way. If you know why you bought your stocks, what you expected from the company and whether it's on track, then you can hold intelligently at those places where others panic. You'll get the rest of the ride up. They won't. Now I have this stock to sell, because I can't stand feeling like a loser.

By Lynn Carpenter (US Stock market analyst)