What Everyone's Forgetting in This Rally

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During last year's stock market meltdown, everyone was too worried about what their investments would be worth the next day to think about their long-term prospects. Now that the market's huge rally has allowed many investors to put the bulk of their financial woes behind them, though, the short-term focus still remains -- and it threatens your long-term financial survival.

Joining the Fad of the Month club
Lately, some people have been trading in and out of stocks faster than you can bar-hop in the French Quarter during Mardi Gras. Many of these hot-market moves have been based on themes like the following:

• Early in the rally, those with an eye toward speculation jumped into threatened companies such as Rite Aid (NYSE: RAD), Hertz Global Holdings, and MGM Mirage (NYSE: MGM). As it turned out, predictions of their imminent demise turned out to be absolutely wrong, and their ensuing recovery turned their stocks into multibaggers.
• As the recovery continued, interest rates on savings continued to fall, and yield-hungry investors looked for alternatives. Investors have pushed strongly into bond funds and ETFs like the iShares iBoxx Investment Grade Corporate Bond (LQD), which holds debt issued by companies, including Wells Fargo (NYSE: WFC), American Express (NYSE: AXP), and Altria (NYSE: MO). That ETF and others have rewarded investors with big gains over the past year.
• In addition, even some once-discarded fads have come back into style quickly. Commodity stocks enjoyed big gains in 2007 and 2008, as prices of oil, gold, and other popular commodities exploded upward. During the last half of 2008, though, the bottom fell out of many commodities markets, bringing stocks like Freeport-McMoran Copper & Gold (NYSE: FCX) and Chesapeake Energy (NYSE: CHK) crashing down with them. But having bottomed out near the beginning of 2009, commodities are marching higher again -- and fad-following investors are following suit.

These trends have made some people a lot of money. The problem, though, is that such episodes teach investors the wrong lessons, and when the methods they learn stop working, it can cause big problems down the road.

Volatility doesn't last forever
One of the reasons why nimble investors have managed to make so much money in this market environment is that there have been so many opportunities to profit. In the wake of the commodities bust, it was reasonable to assume that after running up to extremely high levels, the market would end up overshooting to the downside as well.

Similarly, at March's lows, many stocks were priced for the near certainty of their going out of business. To be fair, at the time it appeared that those business would have to fail -- but risk-tolerant investors took a chance, and it paid off.

But there are two problems with following trends. One is that most trends inevitably reverse themselves. If you're not prepared for those reversals, they can easily turn even huge paper gains into losses.

Second, even while trends exist, they aren't always so dramatic as to produce the kinds of profits we've seen lately in such a short period of time. During most of the 1990s, for instance, oil traded in a fairly tight range, without anything close to the magnitude of monthly spikes we saw in 2008. Similarly, stocks can stay within narrow trading ranges for months or even years. If you get addicted to triple-digit percentage gains, you're setting yourself up for big disappointment in the years to come.

Think long-term
Short-term trading strategies thrive in volatile markets, but many of them don't handle relative stability nearly as well. When you're counting on a big move to make a position profitable, flat markets can be just as detrimental as when those markets move against you.

Even if you've made money from following these profitable trends, now's the time to give up the habit of short-term thinking. The best investors integrate their individual picks into the context of a longer-term plan -- one that provides overarching guidance that can help them avoid big mistakes. Unless you plan for the long run, short-lived profits can quickly turn into permanent losses when money-making trends reverse themselves.

Did you miss the rally? Paul Elliott can tell you what your next step should be.