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Sivy on Stocks

The psychology of investing
Here's how to keep your wits about you and boost your long-term returns.
August 18, 2004: 10:02 AM EDT

NEW YORK (CNN/Money) - Without question, the most difficult challenge investors face is managing their own emotions. They extrapolate current trends and think good times will last forever. Moreover, investors develop a herd mentality, and everyone ends up chasing the same hot stocks.

A 17-part series on how to achieve maximum returns for the right amount of risk. See all the lessons.

As a result, investors typically overpay for the most popular stocks, thinking that rapid earnings growth of 30 percent a year or more will always bail them out. Sometimes it does, but high-fliers with P/Es above 50 rarely keep outperforming the market for long. Even the best glamour stocks can crash -- as many investors learned the hard way during the tech wreck that followed the late 1990s boom.

In fact, the highest-priced growth stocks are often outpaced over a decade or longer by moderate-growth stocks with 12 percent to 16 percent annual earnings increases and P/Es below 25.

Investors make the same kind of mistake with value stocks, seeking out deep-discount situations in hopes of a big score. It's a risky strategy because a lot of cheap stocks are cheap for good reason -- the companies may be in big trouble.

Instead of disasters, value investors should look for moderately depressed stocks, with below-average P/Es -- 10 to 16 nowadays -- and 8 percent to 10 percent projected annual earnings growth. Even modestly better results will help those stocks bounce back.

Extremes in valuation also occur on an industry-by-industry basis. Big drug stocks, for instance, were cheap in the early 1990s, because of fears that Clinton administration health-care initiatives would depress industry profits.

Then in the late 1990s when it became clear those fears were overblown, P/Es for industry leaders such as Pfizer and Johnson & Johnson soared to double or triple their earlier levels.

And since then, those P/Es dropped back down as investors worry about whether drugmakers will be able to come up with new blockbusters to replace those with expiring patents.

To profit from such major shifts in sentiment, you have to be mentally prepared to resist the temptation to join the herd. The simplest and safest strategy is to buy quality growth stocks when they are depressed relative to their historical valuations.

Develop a list of companies you like in a variety of sectors and track them. At any particular time, one of two of the stocks on your list will probably be underpriced.

The key is to buy quality that you can expect to hold for five years, 10 years or longer. If you scoop up such a stock at what is clearly a bargain price, you're almost certain to do well over the long term.

Be contrarian about when you buy -- not what you buy. You don't have to discover stocks no one else knows about. And you don't have to catch the exact bottom to get a terrific bargain.  Top of page

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