Other ways to gauge sentiment range from looking at the behavior of mutual fund investors. Over time, different studies have looked at whether capital is flowing into or out of equity mutual funds. The common pattern is that at or near market highs, mutual fund sales tend to be dominated by equity fund sales and during the period that markets are undergoing a bottoming process, redemptions and inflows into bond and money market funds are usually significantly higher.

As is always the case, no one indicator or set of indicators can be accepted as the sole pillar of good decision making. But investors should look at measures of sentiment, valuation levels and technical factors to build a well balanced approach to gauging market direction.

The “buy and hold” and “invest for the long term” messages are all well and good. But as we have seen for much of the past decade, charging into the markets with capital in hand is a recipe for disaster. Several months ago, Morningstar conducted a study measuring how the average mutual fund investor fared against what each category of mutual fund actually performed. The conclusion: over the last five years, in each mutual fund category, the average investor underperformed the category average. Why was this so? The most likely reason is that investors attempt to “time the markets”, or chase the latest hot mutual fund or sector. Essentially, buying high and selling low.

Time and again, one of the most costly errors for investors is to get aggressive and start thinking about being long term investors well after the market has gone on an extended run only to then panic and sell out when markets decline for an extended period of time. For the prepared investor, market declines should be welcome events – allowing one to capitalize on the inevitable opportunities that other people’s panic creates.

When Sir John Templeton, widely regarded as one of the greatest investors of all time, was asked what made him avoid the hype and eventual crash of technology stocks from 2000 to 2002, he replied: “When people are desperately trying to sell, help them and buy. When people are enthusiastically trying to buy, help them and sell”. In other words, Sir John was saying watch what the crowd is doing and then to consider doing the opposite. For most investors, this is a hard thing to do. But when it comes to investing, it pays to be aware of where extremes in investor behavior are resulting in rationality being replaced with fear or greed. After all, extremes in fear and greed are just reflections of market sentiment.