Why Some Investors Are 28.9% Happier

Sometimes it's good to review the past, both for a proper appreciation of the present and for the lessons that can be gleaned to help us the next time we go through similar circumstances. In light of the recent gains which have carried the market to new all-time highs, it's worth taking a quick look back.

Just a year ago, many investors were throwing in the towel. Consider the plight of Upgraders. (The SMI Fund is a useful proxy for all Upgraders here, due to its daily price reporting.) Upgrading peaked on May 9, 2006 at a share price of $11.62, a year-to-date gain of 16.2%. Over the next month, it gave back all those gains and then some, falling all the way to $9.75. After that brutal drop, the market recovered somewhat, only to swoon a second time.

By July 21 it had put in a second and final low of $9.91, though it was not obvious at the time that the retreat was over. It appeared that a retest of the earlier lows was at hand and there was no evidence that further losses weren't imminent. The outlook was gloomy, to say the least.

Against that backdrop, we had this to say in our Editors' Daily Weblog  last July 26:

. . . A week ago, the AAII members responded to their weekly sentiment survey with a level of bearishness not seen since early 2003. With 58% of survey responders registering as bears and only 24% bulls, that's an extremely high level of pessimism in the market.

For those new to interpreting indicators like these, the key is realizing this is a contrary indicator. While it might seem like a bad thing that so many investors are pessimistic in their market outlook, it's actually a good thing. History shows that when most investors are pessimistic, the market is much more likely to head higher. Likewise, when most investors are bullish (optimistic), look out below. Quite simply put, the herd is always wrong.

The fact that we haven't seen this level of bearish sentiment since right before the market took off in 2003 has to be interpreted as a positive. Of course, it's just one factor, but severe bearish sentiment coupled with the extremely favorable absolute valuation of the stock market as measured by the Fed Model combine to create a fairly compelling bullish case when evaluating where stocks are likely to be 6-12 months from now. The kicker is monetary policy (interest rates), which at this point doesn't look very good. Still, I'm fairly inclined to be bullish at this point. There could certainly be some more rough sailing ahead in the short-term, but my guess is that when we look back a year from now, those who are buying right now will be a lot happier than those who are selling. (emphasis added)

Rarely have truer words ever come out of these fingertips. How much happier have last July's buyers been than the sellers? At least 28.9% happier. That's the amount Upgrading has gained since those comments last July. Those that bought (or at least held on) through the darkest stretch of 2006 are smiling a year later. Those that sold a year ago? Ouch. They've missed one of the more dramatic one-year runs in recent memory.

The takeaway for the next time the market swoons is this: successful investing isn't about knowing more than everyone else (see Forecasting Follies ). It's about having the discipline to stick with your plan when everyone else is beginning to panic. That means buying when your insides are screaming they don't want to. Or holding at times when you desperately want to sell.

The investment skies are bright and sunny today, but they won't stay like that forever. Stormy weather will come back eventually. What you do when that bad weather returns is what will dictate your long-term returns. Thinking back through past experiences like these, where riding the storm out paid off handsomely, will only make it easier to stay the course the next time around.

• SMI's Editorials page
• Huge bearish sentiment - from the Editors' Daily Weblog, July 26 
• Introducing the Sound Mind Investing Fund
• Introducing the SMI Managed Volatility Fund
• Make Sure Your Investment Decision-Making Is Inside-Out

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