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Three Psychological Stumbling Blocks That Kill Profits

Face it, the past 12 years have been horrible for most investors.

This is not necessarily because the markets have been rocky, but rather because the vast majority of investors are hardwired to do three things that kill returns.

You can blame Washington, the European Union, debt, high unemployment, or half a dozen other factors if you want to, but ultimately, the person responsible is the same one staring back at you from your bathroom mirror in the morning.

That's why understanding the bad habits you didn't know you had can be one of the quickest ways to improve your financial wealth.

Here's what I mean.

Dalbar, a Boston-based market research firm, produces annual research that compares the returns of stock and bond markets with those of individual investors. The latest, covering the 20-year period ended last year, shows that the Standard & Poor's 500 Index returned an annualized gain of 9.1%. That stands in sharp contrast with the measly 3.8% gain individual investors averaged over the same timeframe.

Fixed income investors didn't do any better. According to the Dalbar data, t hey gained a mere 1% a year versus an annualized return of 6.9% for the Barclay's Aggregate Bond Index.

In other words, investors' self-defeating decisions contributed to an underperformance that was 58% below what it could have been for stocks and 85.5% below what it could have been for bonds.

Why?

Three reasons: recency bias, herd behavior, and fear.

It's All About Perspective

Recency bias is what happens when short-term focus trumps long-term planning and execution.
It's what happens when somebody yells "fire" and everybody runs for the same exit at once despite having entered through any of half a dozen doors in the auditorium. Simply put, recency is recent knowledge that overrides longer-term thinking and memory.

This is why momentum trading works, for example, or the news channels seem to cover the same stocks at nearly the same time – because a huge number of people are focused on exactly the same companies simultaneously. Logically, they then become the subject of increased attention and tend to move more strongly or consistently.

The question of why is the subject of much debate among human behaviorists, but I chalk it up to the fact that human memories tend to focus on recent events more emotionally than they do longer-term plans that are put together with almost clinical detachment.

And the more extreme the events or the news, the sharper our short-term focus becomes.

That's why, according to "Mood Matters," a book by Dr. John Casti, one of the world's leading thinkers on the science of complexity, "bombshell events are assimilated almost immediately into the prevailing [social] mood" where as longer-term cycles bear almost no witness to gradual change.

If that doesn't make sense, think about what happened on 9/11. Most of the world's major markets bottomed within minutes of each other on short-term panic and emotion. Then, when trading resumed days later, they began to climb almost in sync as highly localized events once again faded into the longer-term fabric of our world.

And that brings me to herding.

The Herd Mentality

We'd rather be wrong in a group than right individually so the vast majority of investors tend to make decisions, and mistakes, together en masse.

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Five Companies to Avoid Until the Eurozone Debt Crisis is Over

U.S. companies with significant exposure to Europe will take a profit hit regardless of how the Eurozone debt crisis shakes out.

The financial strain of Europe's efforts to avert default among its troubled members – Portugal, Italy, Ireland, Greece and Spain (PIIGS) – has set the Eurozone on course for a recession even if its efforts succeed.

Yesterday (Thursday) the European Commission dropped its forecast for growth in the Eurozone to just 0.5% from its previous estimate of 1.8% in May. The commission blamed austerity measures, which were aimed at lowering budget deficits, but ended up eroding investment and consumer confidence.

"The probability of a more protracted period of stagnation is high," said Marco Buti, head of the commission's economics division. "And, given the unusually high uncertainty around key policy decisions, a deep and prolonged recession complemented by continued market turmoil cannot be excluded."

Falling consumer demand has already begun to affect the bottom lines of many U.S. companies that derive large portions of their revenue from the Eurozone bloc.

"In light of cutbacks in government spending, tax increases and waning business confidence, there already has been some [company] commentary on slipping appliances, bearings and heavy-duty trucks demand," Citigroup equities analyst Tobias Levkovich told MarketWatch. "In many respects, these early remarks are a worrisome sign."

For example, General Motors Co. (NYSE: GM) on Wednesday said the debt crisis would prevent it from breaking even in Europe this year. And Rockwell Automation Inc. (NYSE: ROK) on Tuesday warned of declining capital spending in Europe next year.

Although sales to Europe account for only 10% of revenue for the Standard & Poor's 500 as a group, several sectors have far more exposure to the Eurozone.

The auto sector derives 27.6% of its sales from Europe, followed by the food, beverage and tobacco sector at 22%, the materials sector at 19.8%, the consumer durables and apparel sector at 16.2% and capital goods at 16.4%.

"Europe is a major component to the U.S. economic engine and it is a concern," Howard Silverblatt, an analyst with S&P Indices, told MarketWatch. Silverblatt noted that while a European recession may not necessarily take down the U.S. economy, "it has an impact that will move stocks."

Here are five U.S. stocks that have significant exposure to Europe and leveraged balance sheets high – making them risky investments until Europe gets back on its feet:

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MF Global Bankruptcy Exposes Vulnerability of U.S. Banks to Eurozone Debt Crisis

The bankruptcy of MF Global Holdings (NYSE: MF) was a distressing signal to investors that it is possible for U.S. financial institutions to fall victim to the Eurozone debt crisis.

MF Global filed for Chapter 11 bankruptcy Monday after credit downgrades led to margin calls on some of the $6.3 billion in Eurozone sovereign debt the bank held. The position was five-times MF Global's equity.

Although the major U.S. banks have less exposure relative to available capital, their many tendrils in Europe – particularly to European banks – will inevitably drag them into any financial meltdown in the Eurozone.

Even the U.S. banks' estimated direct exposure to the troubled European nations of Portugal, Ireland, Italy, Greece and Spain (PIIGS) is disturbingly high – equal to nearly 5% of total U.S. banking assets, according to the Congressional Research Service (CRS).

And according to the Bank for International Settlements (BIS), U.S. banks actually increased their exposure to PIIGS debt by 20% over the first six months of 2011.

But the greatest risk is the multiple links most large U.S. banks have to their European counterparts – many of which hold a great deal of PIIGS debt.

"Given that U.S. banks have an estimated loan exposure to German and Frenchbanks in excess of $1.2 trillion and direct exposure to the PIIGS valued at $641billion, a collapse of a major European bank could produce similar problems inU.S. institutions," a CRS research report said earlier this month.

Of course, the major banks say their exposure to the Eurozone debt crisis is much lower because they've bought credit-default swaps (CDS) to hedge their positions. Credit-default swaps are essentially insurance policies that pay off in the event of a default.

Unfortunately, this same strategy was one of the root causes of the 2008 financial crisis involving American International Group (NYSE: AIG) and Lehman Bros.

"Risk isn't going to evaporate through these trades," Frederick Cannon, director of research at investment bank Keefe, Bruyette & Woods Inc., told Bloomberg News. "The big problem with all these gross exposures is counterparty risk. When the CDS is triggered due to default, will those counterparties be standing? If everybody is buying from each other, who's ultimately going to pay for the losses?"

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Two Ways To Add Income to Your Portfolio as a Currency Investor

For the past 30 years, my grandfather has been living the retirement dream, thanks to a few strategic stock plays.

Here's the interesting part: My grandfather never knew a thing about stocks. He didn't know how to value them, or when to buy and sell.

But he did know the power of income.

You see, as a child of the Great Depression he saw stocks differently than we do today.
His generation didn't buy stocks for the possible capital appreciation.

Instead, they bought stocks based on the dividend yield – and the consistency of that dividend.

They had lived through uncertain times, so they only trusted investments that offered fairly certain income.

That's why now, as we find ourselves back in uncertain markets, you want to make sure your portfolio includes interest-bearing and dividend-yielding assets.

Passive dividend income arrives no matter what's happening in Greece, or how long U.S. Federal Reserve Chairman Ben Bernanke decides to hold rates at record lows. It comes as long as the company remains strong.

Which means my grandfather's strategy is worth copying.

How to Live Comfortably During Uncomfortable Times

My grandfather started with certificate of deposits (CDs) in the late 1970s and early 1980s. These were the high-interest days, so these CDs paid 16% to18% interest. He got that nice, passive "certain" income for as long as that party lasted.

Then once interest rates dropped and all his CDs matured, he looked for the next round of certain income. He had just retired from the telecom industry and believed AT&T Inc. (NYSE: T) was a good long-term play.

Best of all, AT&T paid a 6% dividend yield. So he wisely invested his CD income into AT&T stock and then sat back and waited.

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Southeast Asia: Strong Growth, Humming Factories, No Debt Crisis

Gloom has enveloped most of the investment landscape these days, but there is still one region that offers strong growth and serious returns.

I'm talking about Southeast Asia.

There was a time when investors scoffed at the likes of Singapore, Thailand, Malaysia and Indonesia. But no one's laughing now. The naysayers currently are all too busy pulling their money out of the regions they always assumed were safe – the United States, Europe, and even the trendy BRICs (Brazil, Russia, India, and China).

Indeed, there are precious few flourishing economies in the world today, and none look as promising as the ones you'll find in Southeast Asia. We're talking about countries that have pro-market governments, thriving manufacturing sectors, ample natural resources, and – with the exception of Singapore – wage levels that can still grow a great deal before pricing themselves beyond their Western competitors.

That's quite a lot by today's standards.

Just take a quick look around the rest of the world and you'll see what I mean.

Searching for a Savior

U.S. growth has fallen off a cliff and no amount of "stimulus" seems likely to get it back on track. Economic growth in Europe is stalled as well, and the continent is further jeopardized by the potential collapse of Greece and the European Union (EU). Even Australia and Canada, both with strong mineral and energy sectors, seem to be slowing as demand wanes in the wealthy West.

Emerging markets seem like a better bet for our money at first glance, but they, too, have problems when examined more closely.

Brazil and China are battling inflation. Brazil has a government that seems unable to stop spending, while China has a thoroughly corrupt government and a banking system with an enormous hidden bad debt problem. Russia is a snake pit, from which a foreign investor is unlikely to escape alive. And India, while growing rapidly, has a serious inflation problem and a government as corrupt as it is economically inept.

Fortunately, one incandescent bright spot shines through the darkness: Southeast Asia. So let's take a look at some of the investment opportunities being illuminated.

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In Today's Crazy Markets, Here's the One Global Region to Invest in Now

Money Morning global investing guru Martin Hutchinson has identified the one global region that he's focusing on as the world's next big profit play.

You'll be stunned to see what he's discovered.

But you'll also be wise to listen.

Read More…

As Greek Debt Default Nears, Investors Need to Take Cover

At this point a Greek debt default is virtually unavoidable, and it could happen in a matter of weeks.

The ensuing chain reaction will upend markets around the world and will almost surely lead to more defaults among the European Union's (EU) other debt-plagued nations, collectively known as the PIIGS (Portugal, Ireland, Italy, Greece and Spain).

The bond markets have already passed sentence, with the yield on two-year Greek bonds spiking to an astronomical 76% yesterday (Tuesday). Yields on 10-year Greek bonds rose to 24%.

By comparison, the 10-year bond yields of another PIIGS nation, Italy, rose to 5.74%. Meanwhile, bond yields for the EU's strongest economy, Germany, have dropped below 2%.

The credit default swap (CDS) markets, where investors can insure their bond purchases against default, agree with the bond markets' verdict. As of Monday it cost $5.8 million and $100,000 annually to insure $10 million worth of Greek debt for five years, which means the CDS market now considers default a 98% probability.

Most European stock markets have been hammered over the past several weeks, with some dropping as much as 25%.

"Default is inevitable," said Money Morning Global Investment Strategist Martin Hutchinson. "Greeks are paid about twice as much as they should be, and that gap can't be solved by austerity."

How Soon is Now

In recent weeks Germany has shown more reluctance to dig deeper into its own pockets to bail out Greece and the other PIIGS. At the same time, Greece has struggled to implement the austerity measures that are required if it is to continue receiving aid from the European Central Bank (ECB) and the International Monetary Fund (IMF).

Greece's budget deficit has increased 22% this year, while its economy is projected to shrink more than 5%.

Every new development appears to bring Greece closer to the brink of default – and some see that happening in the very near future.

"My guess is there will be a Greek debt default by the end of this fiscal quarter – yeah, that means very soon," said Money Morning Capital Waves Strategist Shah Gilani.

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The Only Way to Solve the European Sovereign Debt Crisis

It's often difficult to comprehend – much less internalize – the risks posed by the European sovereign debt crisis.

But understand this: If Europe's problems aren't resolved in an orderly fashion, the stock market drops we saw last month will be small potatoes compared to the steep declines that lie ahead.

So here's the solution: Let the Eurozone break up right now on its own terms. And let a new, stronger euro currency come as a result.

At this point, that is the only viable solution to the problems Europe faces.

So far, everything the European Union (EU) has done to try to subdue this outbreak has come up short. In spite of all the group's efforts, the European sovereign debt crisis continues to snowball, drawing more and more countries into the fold as it gathers momentum.

The trendy solution is to simply expel the weaker members of the Eurozone. That would work if Greece was the only problem, but it's not.

That's why a better solution would actually be the opposite – for the stronger countries to abandon the euro and create their own currency.

European countries with strong economies – Germany, the Netherlands, Finland and Sweden – should simply walk out.

I'd like to take credit for breaking new ground with this idea, but I can't. Former head of the Federation of German Industries, Hans-Olaf Henkel, writing in the Financial Times recently proposed this alternative solution as well.

Still, it's worth subscribing to for a number of reasons.

To begin with, it would absolve the strong countries of their liability to prop up their weak Mediterranean sisters.

It was one thing when only small countries, such as Greece, Ireland and Portugal needed propping up. But now Spain, with a collapsed housing bubble and eight years of bad management, and Italy, with the most debt of any country in the EU, are at risk. Both of those countries' economies are large enough to put a sizeable dent in even Germany's vast wealth.

Even more ominous, storm clouds have started swirling around France, which is still rated AAA but does not deserve to be. The country has not balanced its budget since the early 1970s, and public spending has soared on the back of hopelessly uneconomic schemes such as the 35-hour workweek.

Now the French government has come up with a supposed solution – one that consists entirely of tax increases.

So it's clear now that something must be done. And the solution I support has benefits for both strong and weak Eurozone countries.

The Benefits of Breaking Up

For the stronger countries, leaving the Eurozone voluntarily and forming a new, stronger euro currency would…

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For Rational Investors, Market Uncertainty Equals Profits

There's no question that the Washington fiasco, more commonly referred to as the debt-ceiling crisis, has injected a huge amount of uncertainty to financial markets.

That's bad news for the U.S. economy – which Friday's lousy second-quarter gross-domestic-product (GDP) report demonstrates was already suffering from bad fiscal policy, bad monetary policy and a gross excess of new regulations. This deal didn't really solve any long-term problems, won't head off a federal credit-rating downgrade and all in all only adds to the market uncertainty.

But here's the good news. Uncertainty breeds opportunity – especially for savvy, rational investors.

And with the dark clouds of uncertainty that continue to build over the U.S. economy, we can turn this situation to our advantage in a big way.

Let's take a closer look so that I can show you what I mean …

When Investors Are Certain … But Not Rational

There's an irony about investing that's not lost on savvy, rational investors – even at the retail level: If a market lacks uncertainty, it's awful tough for us to analyze and then invest with confidence.

Just consider the capital markets of the late 1990s. Back then, stocks seemed to be on a steady upward march, posting double-digit gains each year.

The fact that the investing masses believed there was a complete lack of market uncertainty made it very difficult for "rational investors" to invest. Those "rational" players understood that the markets were getting frothy, or speculative – in fact, the warning signs were there as early as the middle of 1996 (six months before U.S. Federal Reserve Chairman Alan Greenspan denounced "irrational exuberance").

The whole tech sector really demonstrated the pervasive belief that stock prices could only go up. After its August 1995 initial public stock offering (IPO), Internet-browser pioneer Netscape Communications Corp. saw its shares double on its first day of trading. And I'm sure we all remember how tech companies in general – and particularly companies with "dot-com" in their title – saw their valuations soar well beyond any rational expectations.

For rational investors, that apparent market "certainty" made it almost impossible to invest with any degree of confidence – short or long.

The market was clearly too high, especially in the tech sector, so buying made no sense. It was impossible-to-gauge euphoric speculation that was driving stock prices – not easy-to-quantify fundamentals. If you bought, you were just hoping that the "Greater Fool Theory" would bail you out with a sale to someone else at a higher price.

Selling the market "short" wasn't the answer, either. Expecting an irrational trend to correct itself is a sucker's bet. And a bullish trend like this one that doesn't correct for five years is an expensive misstep – one that will send stock-market bears straight to the poorhouse.

There was very little un-certainty in the market – the United States was the best economy in the best of all possible worlds and the federal budget was swinging into surplus.

In fact, the only uncertainty to be found was situated far away from U.S. shores. I'm talking, of course, about the Asian economies going into crisis in the summer of 1997 and Russia defaulting in August 1998.

Now there was some market uncertainty that would have let you make some real money.

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Special Report: What is the Greek Debt Crisis, and What Does it Mean for Investors?

With Greece on the brink of default – and hanging over the global economy like a financial sword of Damocles – investors the world over are asking themselves the very same question, day after day: Just what is the Greek debt crisis, and what does it mean to me?

It means a lot.

In fact, the Greek debt crisis could prove to be the first in a series of sovereign-debt defaults that could even infect the U.S. economy, tipping it into a "double-dip" recession and reprising the bear market of 2009.

In short, this crisis is one you need to watch and understand.

Given the stakes, we decided to work with our panel of global-investing experts and put together this Money Morning special report: "What is the Greek Debt Crisis, and What Does it Mean for Investors?"

Our goal was to provide you with answers to some of the key questions about the Greek debt crisis – how it started, what's actually taking place, how it could affect the U.S. economy, and how we expect it to play out.

And with the help of experts Keith Fitz-Gerald, Shah Gilani and Martin Hutchinson, we also answer the most important debt-crisis question of all: "What should you do about it?"

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