As head of research for decades at Merrill Lynch, Bob Farrell established himself as one of the leading 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.
1. Markets Return to the Mean Over Time
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 chatter and turmoil of the marketplace.
2. Excesses Lead to an Opposite Excess
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.
3. 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. Just as in the ancient Tower of Babel story, it's not so. As the first two rules indicate, markets revert to the mean.
(To read more about statistical analysis, see Five Stats That Showcase Risk.)
4. Corrections Don't Go Sideways
Sharply moving markets tend to correct sharply, preventing investors from contemplating their next move in tranquility. 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"). The lesson here is to be decisive in trading fast-moving markets. And always place stops on your trades to avoid emotional responses.
5. The Public Buys Most at the Top and Least at the Bottom
The typical investor, John Q, reads the latest news on his mobile phone, watches market programs 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 already complete and a reversion is usually in progress. This is precisely the moment when John Q. decides to buy (at the top) or sell (at the bottom).
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.
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.
7. Markets are Strongest When They Are Broad and Weakest When They Are Narrow
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 index 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.)
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 sell-off, a "sucker's rally," and a final, torturous grind down to levels where valuations are more reasonable and a general state of depression prevails regarding investments overall.
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.
10. Bull Markets Are More Fun Than Bear Markets
This is 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.)
The Bottom Line
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 twists and turns.