Bob Farrell’s 10 Rules for Investing

Wall Street “gurus” come and go, but in the case of Bob Far­rell leg­end sta­tus was achieved. He spent sev­eral decades as chief stock mar­ket ana­lyst at Mer­rill Lynch & Co. and had a front-row seat at the go-go mar­kets of the late 1960s, mid-1980s and late 1990s, the bru­tal bear mar­ket of 1973–74, and Octo­ber 1987 crash.
Far­rell retired in 1992, but his famous “10 Mar­ket Rules to Remem­ber” have lived on and are sum­ma­rized below, cour­tesy of The Big Pic­ture and Mar­ket­Watch (June 2008). The words of wis­dom are time­less and are espe­cially appro­pri­ate at the start of a new year as investors grap­ple with the dif­fi­cult junc­ture at which stock mar­kets find them­selves at this stage.

1. Mar­kets tend to return to the mean over time
When stocks go too far in one direc­tion, they come back. Eupho­ria and pes­simism can cloud people’s heads. It’s easy to get caught up in the heat of the moment and lose perspective.
2. Excesses in one direc­tion will lead to an excess in the oppo­site direc­tion
Think of the mar­ket base­line as attached to a rub­ber string. Any action too far in one direc­tion not only brings you back to the base­line, but leads to an over­shoot in the oppo­site direction.
3. There are no new eras – excesses are never per­ma­nent
What­ever the lat­est hot sec­tor is, it even­tu­ally over­heats, mean reverts, and then overshoots.
As the fever builds, a cho­rus of “this time it’s dif­fer­ent” will be heard, even if those exact words are never used. And of course, it – human nature – is never different.
4. Expo­nen­tial rapidly ris­ing or falling mar­kets usu­ally go fur­ther than you think, but they do not cor­rect by going side­ways
Regard­less of how hot a sec­tor is, don’t expect a plateau to work off the excesses. Prof­its are locked in by sell­ing, and that invari­ably leads to a sig­nif­i­cant cor­rec­tion eventually.
5. The pub­lic buys the most at the top and the least at the bot­tom
That’s why contrarian-minded investors can make good money if they fol­low the sen­ti­ment indi­ca­tors and have good tim­ing. Watch Investors Intel­li­gence (mea­sur­ing the mood of more than 100 invest­ment newslet­ter writ­ers) and the Amer­i­can Asso­ci­a­tion of Indi­vid­ual Investors Survey.
6. Fear and greed are stronger than long-term resolve
Investors can be their own worst enemy, par­tic­u­larly when emo­tions take hold. Gains “make us exu­ber­ant; they enhance well-being and pro­mote opti­mism”, says Santa Clara Uni­ver­sity finance pro­fes­sor Meir Stat­man. His stud­ies of investor behav­ior show that “losses bring sad­ness, dis­gust, fear, regret. Fear increases the sense of risk and some react by shun­ning stocks.”
7. Mar­kets are strongest when they are broad and weak­est when they nar­row to a hand­ful of blue-chip names
This is why breadth and vol­ume are so impor­tant. Think of it as strength in num­bers. Broad momen­tum is hard to stop, Far­rell observes. Watch for when momen­tum chan­nels into a small num­ber of stocks.
8. Bear mar­kets have three stages – sharp down, reflex­ive rebound and a drawn-out fun­da­men­tal downtrend
9. When all the experts and fore­casts agree – some­thing else is going to hap­pen
As Sam Sto­vall, the S&P invest­ment strate­gist, puts it: “If everybody’s opti­mistic, who is left to buy? If everybody’s pes­simistic, who’s left to sell?”
Going against the herd as Far­rell repeat­edly sug­gests can be very prof­itable, espe­cially for patient buy­ers who raise cash from frothy mar­kets and rein­vest it when sen­ti­ment is darkest.
10. Bull mar­kets are more fun than bear mar­kets
Espe­cially if you are long only or man­dated to be fully invested. Those with more flex­i­ble char­ters might squeak out a smile or two here and there.