Mastering Your Market Mood Swings

Untangling emotions can help you weather the turmoil

Investors, get a grip. Many of you are showing classic symptoms of grief over your decimated portfolios--denial, anger, depression--and you're struggling to attain that final stage, acceptance. Fear drives you to cash out at lows in a volatile market. You're angry and blame others--the conniving chief executive, the money-hungry broker. Some of you still hold out hope that those $10 tech stocks you own will rebound to $80 in this lifetime.

Fear. Blame. Hope. They are all too-human impulses. But they can be highly destructive. From irrational exuberance to irrational pessimism, millions of investors have unwittingly sabotaged their nest eggs with their mood swings. It started with greed--fueled by bull-market hype and dot-com mania. People overestimated their stock-picking abilities and tolerance for risk and gorged on equities. "When investors have some successes, they tend to take on more risk," says John Nofsinger, a behavioral finance professor at Washington State University and author of Investment Madness: How Psychology Affects Your Investing and What to Do About It (Financial Times Prentice Hall, $24). "We felt proud for making all the right decisions, but really we tricked ourselves."

What you need now is a healthy dose of introspection. Understanding the motives for owning and buying stocks will help relieve that nauseating feeling that comes with the pitch and sway of the markets. It's more than just a reading on fear and greed. Bravado can lead you to hold on to losers rather than admit to a mistake. Envy of a neighbor's success often justifies otherwise ill-advised purchases.

Familiarity can be a trap, too. Investors tend to load up on the shares of well-known companies or those they work for--wrongly assuming they're safe. Devoted buyers of blue-chips Walt Disney (DIS ) or Coca-Cola (KO ) in mid-1998, for example, would have since lost 56% and 42% of their respective investments, if they had held on waiting for a rebound.

The good news is that once you master your emotions, you can gain an edge. Contrarian types, after all, profit by capitalizing on the misjudgment of others. "Every great investor thinks independently," says San Francisco hedge-fund manager Peter Moon. They learn "to avoid following the crowd at critical times." Professional day traders, hedge-fund managers--and the market coaches who train them--have developed techniques to do just that. Popping a tranquilizer may be tempting, but developing a new mindset is a better prescription for what ails you in turbulent markets. Here's how:

Keep your eye on the future. One of the biggest mental blocks is short-term thinking. That's why you have to figure out a plan and make decisions that support it. Say you had decided some time ago to keep a 50-50 mix of stocks and bonds. By 1999, you would have sold stocks that had skyrocketed and then rebalanced your investments by buying more bonds. That would have set you up nicely for 2000 and 2001, when the average bond fund rose 8% and 5%, respectively, and stock funds tanked. Right now, you may be doing the reverse--buying stocks and lightening up on bonds.

Besides, investors can drive themselves crazy watching stock prices daily. "You don't open the paper each day and review the price of your home, do you?" asks Neil Hennessey, president of Hennessey Advisors in Novato, Calif. "If you micromanage your portfolio, you will most definitely destroy what you have worked hard to create."

Be realistic. Even the pros have lowered their expectations in the current market climate. You'll have to do the same if you want to make profits, says Ari Kiev, trading coach and author of The Psychology of Risk: Mastering Market Uncertainty (Wiley & Sons, $39.95). Kiev's advice is simple: Be calm, face the truth, and run with your winners. In other words, don't be afraid to stand by your original investment plan in the face of market chaos.

But sticking to your convictions doesn't mean giving in to what Nofsinger calls "attachment bias." Some hang on to so-called stub ends, a few shares held for old time's sake, even though they decided to sell out of a position. It's a mistake that tends to drag down overall performance. By allowing emotions to control investing and trading decisions, Kiev says a lot of investors develop bad habits. And don't make matters worse by adopting a gambler's mentality. Sometimes investors double up on risky stocks and investments in a desperate attempt to make up for previous losses, only to "eventually get killed," says Kiev. "Being macho is not a virtue in the markets."

Admit mistakes. Most investors don't make changes to their portfolio, sticking with the buy-and-hold mentality to a fault. Nofsinger calls it "status-quo bias." Switching out of a losing stock means admitting that the purchase was a poor one--and that hurts.

Many people got so attached to Cisco Systems (CSCO ), for instance, that they continued to pile into the tech darling at a peak of $79 and 187 times earnings and held on all the way down to its current price of $12.65.

When and if they do sell, these investors also suffer from separation anxiety: They tend to buy and sell the same stock over and over. "Even if they finally decide to sell a company, they often feel a sense of loss and keep tabs on it long after it's out of their portfolio," says Nofsinger.

Fear fear itself. Fear is one of the most perilous emotions facing investors. It makes you act quickly, without measuring consequences. "Those people who got scared in July and got out will suffer a huge loss compared with those who hung in there," says financial planner Deena Katz of Evensky, Brown & Katz in Coral Gables, Fla. Katz says her practice has always been about managing clients' expectations; it's just more intense these days.

There's another side of fear that can infect investors' thinking. It manifested itself during the Internet bubble when people got swept up in the herd mentality and chased after hot stocks. "Investors bought what everyone else was buying because they were afraid of getting left behind," says Nofsinger.

Get your priorities straight. Instead of mesmerizing yourself with the gyrations of the stock market, go for a walk. Smell the proverbial roses. Too many people are consumed by worrying about their net worth, 401(k) balances, and at what age they'll retire. It's important to put the market in its rightful place among other aspects of your life. "Your whole life shows up in how you trade and invest," says Kiev. "It's not thinking that when you get to some place in the future, you'll be happy. There is no there, there." Taking a Zenlike approach to life will translate back, in a healthy way, to your view of the market: Rather than stressing out about tomorrow, you'll be confident that each day, your well-conceived portfolio is performing the best it can.

By Mara Der Hovanesian

    Before it's here, it's on the Bloomberg Terminal.