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Tuesday, 10 July 2007

Understanding the Bear Market Psychology of the Investor

Interesting read for those thinking of going against the flow.... :)

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By Jeff Neal

With the Dow and the Standards and Poor's 500 doing quite well, it is important for the investor to take a close look on just how to start playing some defense. More often than not, when the market is experiencing a period of extreme optimism or pessimism, it is time to play contrarian and look to move against the crowd.

The current optimism has the average U.S. equity currently selling for around 19 times trailing earnings, which is higher than the average. However, high P/E ratios do not necessarily indicate a bear market is ahead. In fact, with interest rates and inflation relatively low, a higher than average earnings ratio is exactly what should be anticipated.

It is essential to note though that the current bull market was started around early October 2002 when the Standards and Poor's 500 was around the 780 mark. Since then, the market has been a robust bull market and now is more than four-and-a-half-years old. This makes the bull market a relatively mature one.

Not knowing exactly when the next bear market will occur it is worthwhile to discuss just what goes through the average investors mind when the bears start to appear. Essentially it can be divided into 3 stages. First, the initial downturn is perceived as just a bump in the road, a correction in a continuing bull market. They are confident that the market will quickly bounce back and actually view this event as a buying opportunity.

The second stage is fear when a more serious pullback unfolds. The typical investor insists that they are not going to sell any of their holding at these prices and at the same time refuse to buy anything new. Finally, in stage 3 the investor feels extreme pain and think they are getting killed in the markets. They feel they have to do something to stop the bleeding and they eventually start to sell their holdings.

History has shown that the average investor consistently sells at the bottom despite the bad feeling that comes with doing so. However, there are some things the investor can do to withstand any future bear markets. One thing the investor can certainly do is to invest in less economically sensitive stocks, like utilities, food and drug companies and defense contractors.
In addition, an investor can cut down their exposure to small-cap stocks, which usually get hit pretty hard during a market downturn. The investor should also look into diversifying into foreign markets that are less correlated with the markets in the United States. Another good tip is for the investor to spread their risk among bonds, real estate investment trusts, gold shares and inflation-adjusted Treasuries.

The key thing to remember is that even though we do not know exactly when a bear market will occur, we do know that eventually it will indeed come. With that it mind, it is important to start managing risk, protect profits and make the necessary moves to protect your portfolio. The good news is that when a bear market does start we also know that a bull market will certainly follow.

Jeff NealSenior Writer, Options Strategist & Profit Strategies Radio Show Market CorrespondentVisit Jeff's ForumListen to Jeff at www.ProfitStrategiesRadio.com

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