Investors are feeling cheerful – time to batten down the hatches

Last week, I got a rather worrying phone call.

I was asked to talk to BBC Radio Scotland about whether it was time for listeners to think about "getting back into the stock market". It wasn't for a financial show either it was a general magazine programme.

Why is that worrying? There's a saying in the markets: "if it's in the press, it's in the price." In other words, if a financial trend is hitting the headlines, it's probably nearing the end of its life.

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So when the BBC phones up and asks if it's time to take a punt' on the markets again, just as the FTSE 100 is nearing its all-time high, you can see why I might start to fear for the staying power of this bull market

When everyone else is bullish, it's time to worry

Investors as a group - are awful at timing the market. They buy just as the market is about to tumble. They watch it drop all the way. When they can bear the pain of loss no longer, they bail out. Then it recovers.

I'm sure anyone with any experience of investment recognises this mistake from bitter experience I know I do. Retail' or small investors are often seen as being the most prone to this error. But that's unfair institutional investors are terrible at timing the market too.

A recent academic paper has provided yet more evidence of just how terrible. It's a study by Harvard behavioural economists, Robin Greenwood and Andre Shleifer.

They looked at surveys of investor sentiment ways to measure how optimistic (bullish) or pessimistic (bearish) investors are feeling. These surveys reflect investors' actions pretty well. In other words, when investors are feeling upbeat, they put more money in stocks.

But what is it that makes investors feel optimistic about stocks in the first place? Is it because they're cheap? After all, history shows that in the long run, if you buy markets when they're cheap, you'll make more money.

As Warren Buffett didn't quite put it, you want to buy beefburgers when they're doing a BOGOF deal at the supermarket, not when they're full price. (Of course, you also want to make sure you're actually getting beef. We could stretch out into a whole metaphor on balance sheet due diligence, but I'll leave that for now.)

So if we lived in a rational' world, it would make sense for investors to become more bullish as share prices fall.

Of course, that's not the way it works. When share prices fall, people panic and worry that they're never going to stop. So they sell. And when they rise, people panic and think that they'll never be cheap again. So they buy.

And this is just what Greenwood and Shleifer found. As Greenwood told the Wall Street Journal: "Find any survey you can get your hands on, and they will all tell you the same thing. When prices are high and stock markets perform well, investors expect it to continue going up."

As Gavyn Davies describes it on his FT blog, investors "chase rising stock prices and vice versa." This is known as trend-following' when it's done deliberately by traders, and lemming-like herding activity' when it's done by unwary small investors.

In other words, investors buy high and sell low. So when everyone else is optimistic, you should be pessimistic. Indeed "bullish sentiment [predicted] abnormally low stock market returns over one and, especially, three years ahead," notes Davies.

Given that investors are currently very optimistic, this suggests you should be wary.

Stick with your plan, but take profits on speculative punts

So what can you do? I'm not for a minute saying that you should pull all your money out of stocks. Apart from anything else, you don't know exactly when or how far stocks will correct. Markets could easily see a 10-15% drop from here without it being too significant in the longer run.

But what I am saying is that you should be wary of getting carried away by everyone else's optimism. When all around you are screaming buy' and talking of the great returns to be made on this or that investment, it's hard to keep your eye on the prize.

You should already have a plan for your investing. So stick to it. Keep drip-feeding your money into cheap markets such as Europe and Japan. Keep reinvesting your dividends. Don't worry too much about what everyone else is thinking regular rebalancing of your portfolio will stop you from being caught out too badly by the swings and roundabouts of the market. (If you don't know what rebalancing is, read this piece by my colleague Phil Oakley: How to buy low and sell high.)

All I would say is that if you have made any short-term bets with the more speculative portion of your portfolio recently, and you're sitting on some nice gains, you might want to think about taking profits. (You know what I'm talking about the pot of money you keep aside for following make or break' share tips and the like.)

And one last point trend-following (chasing existing trends) can and does work, as long as you get in and out on time. As Davies notes on his FT blog, they have struggled over the past couple of years, but their long-term track record is good.

However, you shouldn't try to time the market in this way yourself it's incredibly difficult and time-consuming and if you have a full-time job, you won't be able to do it. This is one area where I'd let the experts do it for you. My colleague Tim Price recommended one specific trend-following fund in our New Year Roundtable. If you're not already a subscriber, you can subscribe to MoneyWeek magazine.

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