Herd Mentality

February 16, 2009

Herd behavior in investing is usually not very profitable. Investors who employ a herd mentality investment strategy must constantly buy and sell assets in pursuit of the newest and hottest investment trends.

Herd behavior in investing is usually not very profitable. Investors who employ a herd mentality investment strategy must constantly buy and sell assets in pursuit of the newest and hottest investment trends. For instance, if an investor hears that biotech stocks are hot, he will free up investment capital and pour it into biotech equities. Then, when he learns internet stocks are the place to be, the herd investor will probably dump the biotech stocks and move his money again.

There is nothing wrong with timing your investments. In each bull rally, new leadership is what drives the market advance. The herd is too late in these moves; trying to get on board, as with internet stocks, after the leaders have everyone on board to fit into a “perfect price.”

While the new leaders are campaigned by large institutions, savvy investors learn ways to track new leadership. They know where the money is flowing and into which sectors and industry groups. How you do this is beyond the scope of the article, but there are ways to track the relative strength of specific sectors of the general market. These new leading groups go through a process: phase one is generally accumulation, and then they enter a markup phase. As they top, the leaders are drawing the herd in and the smart, composite operators begin to distribute the stocks while liquidity and trade is easy. From there, the slow decline enters into the mark down mark down and distribution phases.

The herd is generally late getting out of the declining bear market and sits too long on the sidelines. Just as they can't decide the proper time to get into the market, they don’t know when to get out. This is especially evident when the news is all bad and the technical market internals are showing it is time to move.

All this buying and selling incurs a substantial amount of transaction costs and can eat away at any profits. In addition, it’s difficult to time trades correctly so that you are positioned well when the trend begins. Often, by the time a herd investor learns about the latest trend, other investors have all ready taken advantage of the news and the strategy’s wealth maximizing potential has already peaked. Again, herd investors enter the game too late and may lose money as those at the front of the pack move on to another strategy, or invest in sectors showing accumulation and strength. Transaction costs are immaterial in today’s markets where trades can be done for pennies a share. It takes some homework and experience to know how to time your investments, but this can be done with the help of an experienced money manager or advisor.

An investor is usually better off steering clear of the herd and realizing that just because everyone is jumping on the bandwagon, that it may not mean that this is really the best idea. It’s fine to trade and invest when the herd is driving prices higher, but you must know how to read the technical signposts or work with someone who knows when to shift and maneuver in topping markets.

Michael Doran is Managing Director of the long/short equity fund, Emerald Bay Partners LP.

Mr. Doran can be reached at (530) 677-1635 or sierracap@directcon.net.

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