Bob Farrell was the head of Merrill Lynch Research for decades, and during that time he established himself as one of the premier market analysts on Wall Street. His insights on technical analysis and general market tendencies were later canonized as "10 Market Rules to Remember" and have been distributed widely ever since. Let's take a look at these timeless rules and how they can help you achieve better returns.
No.1. Markets tend to return to the mean over time.
In layman's terms, this means that periods of market insanity never last forever. Whether it's extreme optimism or pessimism, markets eventually revert to saner, long-term valuation levels. For individual investors, the lesson is clear: Make a plan and stick to it. Don't get thrown by the daily squawk and turmoil of the marketplace. (You can learn more about how stocks behave in Forces That Move Stock Prices.)
No.2. Excesses in one direction will lead to an opposite excess in the other direction.
Like a swerving automobile driven by an inexperienced youth, overcorrection is to be expected when markets overshoot. Fear gives way to greed, which gives way to fear. Tuned-in investors will be wary of this and will possess the patience and know-how to take measured action to safeguard their capital. (Read more about fear and an omen that predicts sharp corrections in Be Aware Of The Hindenburg and When Fear And Greed Take Over.)
No.3. There are no new eras, so excesses are never permanent.
The tendency among even the most successful investors is to believe that when things are moving in their favor, profits are limitless and towers can be built to the heavens. Alas, as in the ancient Tower of Babel story, it's not so. As the first two rules indicate, markets revert to the mean. Profits have to be taken while they're still profits, lest all be lost! (To read more about statistics, see Five Stats That Showcase Risk.)
No.4. Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.
The big money knows to hold on while a steeply profitable move is in effect (as seen in the trader saying, "let profits run") and to patiently stay in cash in the grip of a market panic ("don't attempt to catch a falling knife"). Moreover, these types of sharply moving markets tend to correct equally sharply, preventing investors from contemplating their next move in tranquility. The lesson: be decisive in trading fast-moving markets. And always place stops on your trades to avoid emotional responses. (You can see more about using limit orders to protect you from yourself at A Logical Method Of Stop Placement.)
No.5. The public buys the most at the top and the least at the bottom.
This is the sad truth of the average John Q. Investor. He's incurably impressionable - and innocent to boot. He reads the newspapers, watches market programs on television and believes what he's told. Unfortunately, by the time the financial press has gotten around to reporting on a given price move - up or down - the move is complete and a reversion is usually in progress: precisely the moment when Johnny Q. decides to buy (at the top) or sell (at the bottom). (Read more about stock news in Mad Money ... Mad Market?)
The need to be a contrarian is underlined by rule No. 5. Independent thinking will always outperform the herd mentality. (For more on contrarian investing, see Buy When There's Blood In The Streets.)
No.6. Fear and greed are stronger than long-term resolve.
Basic human emotion is perhaps the greatest enemy of successful investing. By contrast, a disciplined approach to trading - whether you're a long-term investor or a day trader - is absolutely key to profits. You must have a trading plan with every trade. You must know exactly at what level you are a seller of your stock - on the upside and down. Better still, place stops with each buy order, because once the market begins to move, the world becomes a very different place. (To keep reading on this subject, see Buying Fear, Neuroeconomics And The Science Of Investing Fear and Master Your Trading Mindtraps.)
Knowing when to get out of a trade is far more difficult than knowing when to get in. Knowing when to take a profit or cut a loss is very easy to figure in the abstract, but when you're holding a security that's on a quick move, fear and greed will quickly act to separate you from reality - and your money.
No.7. Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names.
Many investors are "Dow-obsessed," following with trance-like concentration every zig and zag of that particular market average. And while there's much to be gained from a focus on the popular averages, the strength of a market move is determined by the underlying strength of the market as a whole. Broader averages offer a better take on the strength of the market. Instead, consider watching the Wilshire 5000 or some of the Russell indexes to get a better appreciation of the health of any market move. (Get to know the most important indexes in our tutorial on Index Investing.)
No.8. Bear markets have three stages - sharp down, reflexive rebound and a drawn-out fundamental downtrend.
Market technicians find common patterns in both bull and bear market action. The typical bear pattern, as described here, involves a sharp selloff, a "sucker's rally", and a final, torturous grind down to levels where valuations are more reasonable; a general state of depression prevails regarding investments in general. (Learn about how your portfolio should evolve in bad times at Adapt To A Bear Market.)
No.9. When all the experts and forecasts agree, something else is going to happen.
This is not magic. When everyone who wants to buy has bought, there are no more buyers. At this point, the market must turn lower and vice versa.
No.10. Bull markets are more fun than bear markets.
This true for most investors - unless you're a short seller. (If you want to enjoy the bear markets by short selling, check out our Short Selling Tutorial.)
Many investors fail to see the forest for the trees and lose perspective (and money) unnecessarily. The above listed rules should help investors steer a more focused path through the market's vicissitudes.