Investing and the Herd Mentality

When investing your money, a good axiom to remember is that it’s usually wise to avoid following the herd. By the time your friends, family, neighbors and the newspaper columnists are all investing in a particular sector or security, it’s often too late to be any benefit to you because the hype has already inflated the price. Whenever investment dollars rush in, prices soar and savvy investors usually move on. The real money has been made and only the sizzle remains. By the time the mass of average investors have caught on to a new fad, prices are often too high and investments are overvalued, making them a risky choice for investors who are seeking value.

The herd mentality is a well-documented pitfall among investors and it can have striking consequences for investment performance. Investment clubs, which were popular during the 1990s, were studied in regard to the dangers of group-think. These clubs, composed of amateur investors, often favored certain sectors and investment types to the exclusion of all other types. Researchers found that portfolio returns of investment clubs lagged the S&P 500 Index by 3.7% per year, meaning that members did worse as part of the group than the market overall during the same period. 

Wise investors focus on value when evaluating investment options. Too many investors focus on buying into market trends and economic outlook, not realizing that trends can be deceiving and markets often perform very differently from the economy. Individual stocks can easily surprise you – rising in a down market, and falling during a rally – making it important for long-term investors to focus on buying quality investments with good fundamentals.

While economic trends can exert a powerful effect on market movements, the stock market and the economy do not move with perfect correlation and there are many occasions in which markets rally in spite of poor economic fundamentals or declining corporate earnings. This is not to say that economic outlook is unimportant. A smart investor keeps an eye on the economy and factors economic outlook into investment decisions, but ultimately seeks high-quality individual investments.

A fast buck might be compelling, but most smart investors would rather invest in a company that has substance and is more likely to provide good returns. With time at a premium, chasing the herd could result in a double loss…investing good money on a bad idea, and losing a most precious commodity…time.

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