If you've been reading StreetAuthority Daily for any length of time then you know that I talk a lot about emotions and how they can greatly impact whether you're successful or not in investing... and really everyday life. But we'll stick mostly to investing in this issue.
Gaining a better understanding of the emotional behavior of investors -- commonly referred to as behavioral economics -- can not only help you avoid common pitfalls that plague average investors, but it can also help you better understand momentum investing.
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You see, when it comes to finance and money, humans don't behave rationally (part of the reason why we have momentum investing at all). When it comes to profits and losses, the fear of losing money greatly outweighs the joy in achieving additional gains. It's this very premise that has created the mantra, "Let your winners run, and cut your losers short."
How many times have you sold a winning stock just to see it keep climbing in the days and weeks that followed? And on the flip side of that, think about how many times you've held on to a loser just to see it keep falling. That's a lesson I learned the hard way: Early in my career, I clung to a losing stock as it kept drifting lower -- hoping, praying and wishing for the day it would get back near my entry point so I wouldn't have to sell it at a loss. Guess what? Nearly a decade later, it's still nowhere near my entry price.
It's these very tendencies that we aim to avoid by using my Maximum Profit system -- a strategic, rules-based, emotionless strategy to help guide us through the complex global financial markets.
But it is behavioral economics that helps explain why there are anomalies in the market, such as momentum investing. Before we get into that, we must first look at what conventional economics says...
The Problem With The Classic View
As it pertains to the financial markets, convention has it that if there are stupid, irrational humans in the marketplace, they will be met with rational, smart humans who will take advantage of any irrational behavior, thus bringing the market back to rational levels. For example, if investors turn sour on shares of Apple (Nasdaq: AAPL) and begin selling them, then these smart people will jump in and buy them up as they become undervalued. In the end, not much will happen to the price of Apple shares.
But if everything were rational, how do we explain when closed-end mutual funds (those with a fixed number of shares that trade on exchanges) sell at a premium or discount to the value of their portfolios? If everything were rational, wouldn't they sell for exactly what they are worth according to their portfolio? Or how about the stock of the same company that trades on different exchanges trading at different prices?
Other examples of rationality being thrown out the window can be seen in the lead-up to each of the two recent market peaks. During the dot-com bubble, investors were buying penny stocks and if they had a ".com" in the name they would soar by hundreds of percentage points. No sales. No profits. No problem. Investors would still pile in willy-nilly. Forget about rationality.
Then there was the housing bubble. Real estate was king. "Home values don't go down." That was the "wisdom" of the day. Try to tell someone who was fully invested in that bubble that real estate on average historically appreciated a modest 3%-4% a year and they would blow you off... clinging to the belief that house prices would go up 20% a year, forever.
Clearly, neither of those situations ended well for investors. But if you're part of the bubble, rational arguments don't matter. Again, when it comes to money, most humans don't behave rationally.
Human psychology is fascinating, especially when it comes to money. But it can also give us clues as to where we might be in today's market. At the peak of markets, investors are fearless. Nothing deters them. Their beliefs in sky-high returns outweigh rational questions one would typically ask.
Of course, there's no indicator or survey that tells us when we reach that point. It's more of a "feel" among investors. You might a suspicion or two looking back on the dot-com and housing bubbles.
I bring this up because I don't believe we've reached that point yet in this stock market -- the "euphoric" stage of the bull market, if you will. But having an appreciation of behavioral economics will give us a leg up on protecting the profits we've gleaned before it's too late.
And if you're caught up in the jubilation, you'll need the Maximum Profit system more than ever...
2 Small-Caps With Pristine Balance Sheets
Part of what my system does is flag stocks with promising price movements and improving fundamentals. This allows my Maximum Profit readers and I to recognize stocks that are ready to take off -- in any market environment.
This month, my system has picked up on two promising small-caps -- that is, companies with a market cap under $2 billion.
One is a marketing software company that's managed to triple its cash flows year-over-year -- placing it in the top 7% of all firms growing cash flow. It also carries no debt and continues to expand in its already rapidly growing industry. To top it all off, my system has given this stock a "relative strength" rating -- a measure of price performance -- of 98, one of the highest possible scores. I'm excited about this one to say the least.
The other is a provider of a new service to the business world -- technology business management (TBM). This company actually pioneered this new software category and has been enjoying its first-mover status ever since. And that advantage is significant when you're talking about a potential $2.7 trillion market. This, along with strong fundamentals and encouraging price movement, make this stock an easy recommendation.
With luck, we'll one day be able to add these stocks to our long list of home runs. Over the past three years, my subscribers and I have seen gains like 181% on Lannett (NYSE: LCI), 135% on Westmoreland Coal (Nasdaq: WLB), and a striking 242% on Bitauto (NYSE: BITA). Each time, the Maximum Profit system has told us exactly when to buy and when to sell, while we just sit back and count the returns.
It's that easy.
So if you're interested in making this kind of money with runaway stocks, I strongly recommend you give my premium service, Maximum Profit, a risk-free trial. That way, you'll have a winning system that uses proven fundamental and technical indicators working for you. You'll no longer have to worry about what to buy, when to buy -- or when to sell. Simply let Maximum Profit do the work for you. To learn more, simply follow this link.
This article originally appeared on StreetAuthority.com.