Investors are often spectacularly bad at investing. Alan Greenspan, the former chairman of the US Federal Reserve Board, coined the phrase "irrational exuberance" back in 1996. He was, famously, talking about investor behaviour during an overheating market, when everyone keeps on buying an asset even when all the signals point to a bubble waiting to burst. And it's not just retail investors who make mistakes. Studies of the performance of the best-paid market professionals, such as analysts and fund managers, show that they mostly get it wrong when predicting markets. However, all hope is not lost for investors looking to profit from superior insights into the possible future direction of the markets. Some basic and very simple tools can help investors to piece the puzzle together and make rational investment decisions over time. Here are some of our favourites. 1 Understand the historic price movements of any assets you want to buy. It is critical to have a good impression of historical price movements. We are not strong followers of technical analysis, but some basic techniques can very quickly provide useful insights. For example, if a share price has rallied strongly in recent weeks or months, it is normally prudent to wait for a period of more stability before making the investment. How do we know the right time to buy? The economist E S C Coppock developed an excellent, if slightly morbid, indicator of long-term price movements. Coppock wanted to identify buy signals for the Dow Jones index following a downturn. His insight was that stock market downturns are like a bereavement, both of which require a period of mourning. So Coppock did some research and found that most people in bereavement will recover after 11 to 14 months. While he applied this research to the Dow Jones index in New York in the 1960s, it has since proved useful in understanding other stock markets. Current readings on the Coppock indicator for the Dow Jones already point to an extreme oversold position, though not quite as bad as during the 1930s. 2 Perform some basic valuations. Many a poor investment would have been avoided if the investors spent a little time analysing the fundamental value of the asset. With hindsight, it is often easy to spot the major pitfalls. For example, the Saudi equity market in early 2006 traded on a price to earnings ratio of 44 times (compared with a long-term average of around 12 to 15 times). Or take the NASDAQ index in early 2000, trading on a earnings multiple of 100 times plus. During these periods, many investors are convinced that it "will be different" this time. It rarely is. Current valuations for regional and international stock markets seem fair, compared with their long-term averages, although one has to caution that, in times of extreme uncertainty, profit forecasts become very difficult. And that obviously makes market and stock valuations equally difficult. 3 Study the macroeconomic and political environment. This is often the most difficult aspect to get right, not only for professional analysts but also for part-time investors. The future is unknown, and it is often difficult to establish a reasonable outlook beyond extrapolating the most recent past. A top US fund manager once capitulated with the admission that "we do not know what tomorrow will bring, we therefore might as well think that it might be nice". We have found that markets often get the major turning points right, leading macroeconomic developments by somewhere between three and 12 months. Take recent developments in the US housing market. A comparison of the movement in the S&P Homebuilders Index with the Case-Schiller physical home price index shows that the market prices of listed home building companies in the US started to turn down at least six months before the prices of houses began falling. Today, a range of global stock and bond markets are relatively strong. If we take this as an indication of the future direction of the real economy, one has to be somewhat optimistic that a recovery in the global economy is not too far away. Closer to home, we have also noted the very strong performance of real estate and financial stocks on the Dubai and Abu Dhabi markets. The market is telling us that better macro news is heading our way. 4 Protect your downside risks. We can attempt to strike a balance between risk and reward, but in the end we cannot be certain that our estimates will be correct. Therefore, we should look at some downside protection. Very often the cheapest and best protection comes through proper diversification, but even that approach will not protect against the "iceberg" or "black swan" events when they come around. As such, we should consider employing proper downside risk management techniques, such as buying out of the money put options where appropriate. 5 Study the sentiment of other investors. We consider it extremely important to watch the actions of other investors, not necessarily to find out what they are doing - although we may get some good ideas - but more to gauge the market sentiment. Sophisticated software can now provide counts of the time that certain keywords such as "recession" are used in newspaper or magazine articles. Less sophisticated but equally useful is to listen to other investors to find out what the latest "hot tip" would be. That is more often than not the one to avoid, especially if it gets repeated often. In the words of the famous investor Sir John Templeton: "Bull markets are born on pessimism, grow on scepticism, mature on optimism and die on euphoria. The time of maximum pessimism is the best time to buy and the time of maximum optimism is the best time to sell." The extreme pessimism of the past 12 months is busy giving way to better market sentiment. The best buying opportunities taken by brave investors at the beginning of this year may have passed, but there are always opportunities for long-term investors who base their picks on sound principles rather than "irrational exuberance" and other flawed strategies. Deon Vernooy is a senior executive officer at Emirates Investment Services
