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Blog : Wall Street, Roller Coaster Psychology, and the Penny Stock
by John Whitefoot on October 17th, 2008
The local amusement park near me is advertising a haunted Halloween night; you can ride the coaster and walk through a haunted house. And it’s the perfect pairing too because amusement park haunted houses and roller coasters feed on the same basic fear: loss of control.
Once a coaster takes off, all you can do is sit and scream. Said one amusement park’s publicity director, “Roller coasters get the adrenaline going and there's a challenge in it--overcoming your fear.”
The roller coaster ride on Wall Street has investors of every ilk attempting to do the same thing. After a few painful weeks on Wall Street, penny stock investors may be wondering if the roller coaster ride is over; or do we need to hang on some more?
After all, the S&P 500 saw its steepest one day sell off this week since 1987 and the stock market is hovering around five-year lows. Including Wednesday’s drop, the DOW has plunged 35%; the S&P 500 38% since the start of the year.
Indeed, this week’s numbers are an unpleasant reminder that penny stock and monolithic large-cap investors have been on an emotional roller coaster ride as our assets have experienced some pretty serious drops.
Want to avoid getting hurt on Wall Street's emotional roller coaster ride to nowhere? Experts say you can do more self harm to your investments than the market itself can by reacting to negative news in an irrational way.
If you’re a seasoned penny stock investor, you know that the markets move in cycles, some uglier than others. But in the end, the markets always rebound. This is not quite so obvious for those on their first ride.
Behavioral finance psychologists (yes, you read correctly) have identified a range of situations where investors respond to financial markets in a way that is irrational or illogical. By understanding how your brain responds to certain situations, you can avoid making bad decisions that could cost you dearly.
Over & Under Reaction - Investors (not just penny stock) often put too much weight on recent news – at the expense of other data. They tend to be more optimistic when markets rise and pessimistic when they fall. On the surface, this makes total sense.
“Overreaction is when markets fall drastically and people say ‘lets get out’, which means they miss out on the rebound. Under-reaction is when markets are at the top and the logical response should be to take profits. But people are enjoying the ride, so they stay on for more and end up missing the peak,” said one British financial advisor.
Regret Theory - This is something we have all experienced. Regret theory is the impact of our emotional reaction to having made an error of judgment. When you’ve purchased a stock that’s gone down or missed out on one that went up, we can find ourselves regretting our decision. Often times we will act irrationally to make up for it. For falling stocks this can mean refusing to sell. For rising stocks, it could mean following the herd.
Prospect Theory- This affects those who become prepared to take greater risks to recover a previous loss. Even those who are risk-averse can find themselves becoming risk-takers to recoup their losses.
“Going back to the basics of financial advice is important if you are the sort of person who finds market swings hard to stomach,” said the same advisor. “Our research shows that people feel the pain of loss twice as strongly as they feel the positive experience of gain.”
Does the Wall Street roller coaster of terror mean penny stock investors are in for more pain? Not necessarily. By many measures penny stocks are downright cheap. Analysts at one research firm calculate a “fair value” for each of the approximately 2000 stocks they track. On average, those stocks now trade at about 72% of the fair value estimate.
For penny stock investors (and I have no data to back this up...) all things considered, that number could be much lower. After all, a penny stock has a greater speculative value built into its core price.
While the stock markets may not have yet bottomed out, it doesn’t mean penny stock investors need to ride the investing roller coaster of fear. Despite the bad news and downward trends it’s important to remain objective.
That objectivity may illuminate the fact that, on a fundamental valuation, your favorite penny stock may be a solid buy.