Investing Principle #7 – Investor Psychology, Don’t Follow the Herd

This is part of a larger article called The Golden Rules…

I define Investor Psychology as the herd mentality that is so obvious when you watch short-term stock market behavior. It seems that most investors are willing to follow each other up mountains and off cliffs simply because that’s what everyone else is doing. There are tons of outstanding examples to illustrate this lemming-like behavior, but we’ll go with a a Google example since it’s a company almost everyone has heard of.

Bear Stearns, a major investment brokerage, made some very bad bets on sub prime mortgages and was on the brink of bankruptcy. JP Morgan Chase and the Federal Reserve Bank announce a deal to buy out the troubled brokerage on 3/17. JP Morgan winds up paying an unbelievable $10 per share for a stock that had traded for $100+ per share as recently as three months ago.

Some professional analysts and news pundits begin clamoring that we can “expect to see multibillion dollar companies falling like dominoes in the weeks and months ahead.” They pronounce that we “may be going beyond recession and into a depression” and that “the inevitable crash we’re experiencing is a result of the worst liquidity and banking meltdown this country has ever seen.” Many investors panic and immediately flee the market thinking cash, treasuries, and bonds are the safer bet until they can figure out what the market is going to do.

As a result, Google’s stock price plummets by 4.12%. $5.7 Billion in Google shareholder value (market capitalization) is lost in a single day. Wait a minute… Google is a global company, not just a US company and they’re not even in the financial sector, right? Right. And Google continues to post strong earnings, great growth and is dominating their competitors in market share and revenue growth, right? Right. Google still has the same solid management in place and isn’t in any sort of financial, litigation, or other major trouble either, right? Right. So what the #^% happened? In short, investor psychology. When people panic you see a lot of short term fluctuation in share prices as a result of their behavior.

3/18/2008… One day later:
The Federal Reserve Bank holds its monthly meeting and slashes interest rates by 75 basis points. They calm fears by reminding people that inflation is in check, promise to keep pumping cash in to ease the liquidity crunch, and demonstrate again that they are willing to do whatever is necessary to stabilize the economy and avoid a prolonged recession.

Professional analysts and news pundits are clamoring again but this time they tell us that the Fed is making some brilliant moves. “They have revived measures not used since the great depression, pumped over $200Billion dollars into the system to ease liquidity, and gone on the most aggressive rate cutting spree we’ve seen since the early 1980s banking crisis.” They assure us that the Fed has done so much that we are going to see strong price action in the coming weeks and months and are likely to avoid a recession. The same investors that panicked yesterday panic again, but this time they are flooding back into the market for fear of missing out on a big rally (which they ironically create).

Only one day later, Google’s stock price soars by 4.59%. $6 Billion in Google shareholder value is created in a single day. Do you think Google’s true value really changed so drastically in a two day period? Of course not. There is simply a lot of volatility in the short term, which is why you need to understand a little about investor psychology, so you can avoid the herd.

In the example, the herd sold on the way down and bought on the way up. If you buy high and sell low you are guaranteed to lose money. Unfortunately we are programmed to act this way, your mind will try to get you to make stupid stock market moves whenever you are scared or stressed, you’ll have to make a conscious effort to avoid these mistakes. Warren Buffet once said “simply attempt to be fearful when others are greedy and to be greedy when others are fearful” and I think that’s brilliant advice.

To avoid all of this unnecessary stress, master your own psychological impulses. Hold on to your winners for as long as you can, at least a year, and don’t let short-term market volatility scare you into or out of the market. Why? Long term investors win, short term investors lose, and that’s not a theory, it’s a fact. Also, avoid bouncing between strategies when the market changes, reacting to news, or trying to time the market by moving back and forth from cash to stocks. If you understand your strategy and are good at implementing it, you should wind up with high quality stocks that you bought at a good price and that you can hold onto for a long period of time.

Best of luck and please add your thoughts to this post, we’ll all benefit from your questions and insights.
~ Odd

Back to main article, The Golden Rules…

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