Table of Contents
Bob Farrell, a renowned market analyst at Merrill Lynch, offered invaluable insights on market trends and technical analysis. His famous “10 Market Rules to Remember” are widely respected and followed on Wall Street. Let’s dive into these timeless principles and explore how they can help enhance investment returns.
KEY TAKEAWAYS
- Investors must recognise that prices fluctuate constantly, and market corrections are inevitable over time.
- Keep in mind that excessive gains don’t last forever, and consider using stop orders to trade without letting emotions influence your decisions.
- Resist following the crowd and focus on discipline instead of allowing fear and greed to drive your decisions.
- Consider examining various indices to assess the overall performance of the market.
- Exercise caution when evaluating expert advice and forecasts.
1. Markets Return to the Mean Over Time
Whether the market is overly optimistic or pessimistic, it tends to return to more reasonable long-term valuation levels over time. This means that both returns and prices typically revert to their starting points. For individual investors, the key is to create a plan and stick to it. Take into account everything happening around you and make decisions based on your best judgment. Avoid being influenced by the daily market fluctuations and noise.
2. Excess Leads to an Opposite Excess
Market movements can resemble a car driven by an inexperienced driver, often swerving unpredictably. When markets rise or fall too sharply, an overcorrection is likely to follow. A correction refers to a significant shift, typically a 10% drop from an asset’s highest price. An overcorrection involves even more extreme movements. Market crashes can present valuable opportunities to buy assets at lower prices, but overreactions can cause prices to swing wildly, either up or down. Smart investors understand the importance of patience and knowledge, carefully navigating these fluctuations to protect their investments.
3. Excesses Are Never Permanent
Even successful investors can fall into the trap of believing that profits will keep growing indefinitely when things are going well. However, in finance, nothing lasts forever. Whether you’re buying during market lows or selling at highs to make a profit, always remember not to count your chickens before they hatch. Eventually, you may need to act, as markets tend to revert to average levels, as highlighted in the first two rules.
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- Important: Over time, market prices generally revert to their average levels.
4. Market Corrections: Don’t Go Sideways
In highly volatile markets, sudden corrections can cloud investors’ decision-making. The key is to act decisively and use stop orders to manage emotional reactions.
Stop orders serve two important purposes when asset prices fluctuate. They help investors limit potential losses by establishing a clear exit point for trades, and they also allow them to lock in profits when prices change.
5. Public Buys Most at the Top and Least at the Bottom
Many investors rely on news from their phones and market programs, often accepting it at face value. However, by the time the media reports a price change, it’s usually too late to act, as the market has already shifted in the opposite direction. This often results in the mistake of buying at the peak or selling at the bottom.
It’s essential to think independently and avoid following the crowd. Contrarian thinking—challenging popular opinion—often yields better results than simply succumbing to the herd mentality.
- Tip: Discover Investopedia’s 10 Rules of Investing by grabbing a copy of our exclusive print edition.
6. Fear and Greed: Stronger Than Long-Term Resolve
Emotions like fear and greed can significantly harm your investments. Whether you’re in it for the long term or engaged in daily trading, maintaining a disciplined strategy is essential for success. Having a clear plan for every trade, including knowing when to sell your stocks, whether they rise or fall, is key.
Knowing when to exit a trade is often more challenging than deciding when to enter. While, in theory, it seems straightforward to take profits or cut losses, emotions such as fear and greed can cloud your judgment, making trading decisions harder.
7. Markets: Strong When Broad, Weak When Narrow
While focusing on popular index averages can be useful, the true strength of a market’s movement depends on the overall health of the entire market. Broader averages provide a clearer picture of the market’s strength. That’s why tracking a variety of indexes, not just well-known ones like the S&P 500, is crucial.
For a deeper understanding of market health, consider examining indexes like the Wilshire 5000 or some of the Russell indexes. The Wilshire 5000 includes nearly 4,000 U.S.-based companies listed on American exchanges, offering a comprehensive market view. Meanwhile, Russell indexes, such as the Russell 1000 and Russell 3000, weight companies by their market value, providing investors with a broad exposure to the U.S. stock market.
8. Bear Markets Have Three Stages
Market analysts often observe recurring patterns in both strong and weak market conditions. A typical weak market pattern begins with a sharp drop in prices. When the market weakens, prices typically fall by at least 20%, usually affecting entire indexes. This scenario often coincides with a struggling or slowing economy.
Following this, experts note a phenomenon known as a “sucker’s rally.” This occurs when prices temporarily rise quickly, attracting investors who believe they can profit, only for the prices to fall sharply again. These rallies, driven by speculation and excitement, are short-lived. The investors who get caught in these rallies are often called “suckers” because they buy at a temporary high and lose money when the prices inevitably decline.
The final phase of a weak market is a gradual decline in prices until they settle at more reasonable levels. During this period, investor sentiment tends to be pessimistic, and many feel uncertain about future investments.
9. Be Mindful of Experts and Forecasts
It’s not magic. When everyone who wants to buy has already bought, there are no more buyers, and the market has to go down. Similarly, when everyone who wants to sell has already sold, no more sellers are left. So when market experts and predictions tell you to sell or buy, remember that everyone else is doing the same thing. Things might have already changed by the time you decide to join in.
10. Bull Markets Are More Fun Than Bear Markets
This is true for many investors because prices keep increasing during these times. Who wouldn’t like to see their profits grow? Except for short sellers. Short selling is when you sell something you don’t own. Traders who do this borrow securities and sell them, hoping the price will go down. Later, they must return the same number of shares they borrowed.
The Bottom Line
Investing isn’t straightforward. There’s a lot at stake and an overwhelming amount of information to digest. Whether you’re new to trading or a seasoned market observer, it’s easy to get caught up in market news, emotions, and the surrounding chaos. However, if you follow Bob Farrell’s proven tips, you may find yourself ahead in the game.
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