The U.S. stock market has been hot, to say the least. Year-to-date the S&P 500 is up 20.14%. The trailing 3-year period returns have averaged 16.97% annualized. With stocks hovering around all-time highs, some are left thinking, “Did I miss it? Or can I jump in now and catch some of this bull market?” This is one of the greatest dilemmas for the average investor: the tug-of-war between the dual fears of missing a rally or buying in just to see that rally fade and the market fall. The question then is, “After a long run of highly positive returns, what is the best way to get in to the market?”
One of the most basic (and important) investing philosophies is buy low, sell high. However, too often investors jump on the latest bandwagon and do just the opposite – buy high, and sell low. Going deeper into this phenomenon, we can trace this adverse decision making to a few behavioral traits that most investors possess instinctively: anchoring, overconfidence, and herd mentality.
Anchoring occurs when investors put far too much weight into recent events when making investment decisions. The result is that these decisions are based not on long term fundamentals, but on only the most recent trends. Humans are, by nature, serial interpolators. We tend to project the current circumstances indefinitely into the future, even when this is not realistically the case. As investors, it is important to realize this tendency, and to strive to make decisions based on realistic long-term assumptions rather than short-term trends.
Overconfidence is another behavioral short-fall in which an investor places too much credence in his/her ability to predict the market or pick investments. An investor who is biased by overconfidence by a good run in the market may under-diversify, or underestimate the risks of such an investment. It is the hallmark of a seasoned investor not to get overconfident when times have been good.
Finally, it is important to realize that as investors, we are also human. Throughout history, it has always been in the best interest of a human to follow the herd. Humans have been living and surviving for tens of thousands of years, but only investing for a couple hundred years. The instinct that compels us to follow the herd for comfort and survival acts exactly counter to investing success. Thus, it is important to realize that blindly following a herd will not always yield the best results.
So what is one to do when faced with the temptation to chase a hot market? As always in investing, patience is key. The decision to enter the market should be based not on a rush to chase performance or jump into a rally, but rather, on careful fundamental considerations. It may very well be the case that after a series of highly positive returns, the market seems to be fairly valued on fundamentals. Or, it could be the case that the market as a whole has become detached from fundamentals and is overvalued, but good investments still present themselves within certain sectors or industries. There is no golden rule or blanket recommendation for when to buy into a market rally, but investors should tread lightly, be aware of their own biases, and invest for the right reasons. Don’t chase performance solely for a quick return – Buy low, sell high, and be patient above all else.