Sentiment Investing: You Can’t Win If You Don’t Finish

Posted on January 7, 2013 at 8:00 AM PDT by

“Psst! Want in on a secret new way to ‘know’ what’s going to happen in the markets? Look no further…” Sounds great, right? And that’s the implicit promise of trading systems and sentiment investing indexes.

You hear about sentiment investing all the time in the financial press. The things they purport to measure vary, but the idea is the same: This one sentiment investing indicator drives it all, so forget about trying to guess market direction and wait for “the signal.”

Some of the better-known ones include:

  • The Baltic Dry Index (BDI), which measures the supply and demand for cargo ship space. Supposedly, freighter space demand can’t be faked or manipulated, so the BDI is an indicator of economic growth or slack.
  • The Exchange Market Volatility Index (VIX), a measure of trading frequency for options on the S&P 500 stock index. Since options are about the very near-term future (about a month), movement in the VIX is thought to predict an increase in trading. That could be buying or selling. In practice, of course, it implies both.
  • The Shiller P/E, named for Yale Professor Robert Shiller, has an admirable goal. The “normal” price-to-earnings (P/E) ratio examines stock prices in relation to net income over the most recent 12 months. Shiller felt this approach was too narrow, so his inflation-adjusted P/E calculation looks back 10 years. Both types of P/E attempt to predict the relative “cheapness” of the market in relation to the historical average.

To these well-known sentiment investing cheat sheets we now get to add the “IMX,” which stands for Investor Movement Index.

This new product, produced by the brokerage TD Ameritrade, tries to offer a clear window into the sentiments of 6 million retail investors at the brokerage. Big or small, active or passive (although trading at least once periodically), it’s a sample of everyone at once.

It’s an interesting idea, and there is some early evidence that the index shows how retail investors — often seen as rubes whose sentiment should be taken with a grain of salt, if not traded against directly — actually sort of know what’s up with their money.

As CNBC notes, they were right about the “fiscal cliff” outcome, buying into the market on the supposition that a solution would be found after all.

So, drop everything and trade the IMX? Hold on there.

As TD Ameritrade notes, the index is a look back, not forward. That’s generally the problem with all sentiment investing indexes, even futures. It’s still information based on what people believe is going on, which is by necessity based upon whatever just happened, that is, the recent past.

Markets are wide and deep, far more than any given individual and his or her retirement pot. Like a rogue wave in high seas, information at times breaks one way but quickly falls the next. Thus there’s very little that sentiment investing can do to accurately direct money to profitable positions.

Because of the rapidity of computerized trading, new information in the market also quickly loses its limited value. In milliseconds in some cases. Retirement investors cannot use sentiment investing to outgun the pros. Increasingly, even the pros can’t outgun the pros.

Sentiment investing: set it and forget it

What’s the small investor to do? First of all, stop trying so hard. If your most sincere wish is to worry less about money, that’s actually a great approach to investing. Set up a reasonable asset allocation and rebalance once in a while.

Secondly, stop trying to “win” at investing. You have a lot of races to run over the years. You’ll find that finishing well in the pack is a great place to be over the long term. Compounding will see to that.

Yes, that zero body fat sprinter of a trader might get the glory this quarter or next, but he’s very likely to stumble from exhaustion in the next race. Just stay in, keep your head down and focus on the big picture, and you’ll get there.