By Brett Owens
Our natural human-herding instincts often serve us well in life because they allow us to look to our family, friends, and neighbors for clues on how we should interpret and react to a situation. Given the complexities of modern life, it’s impossible for someone to know everything about everything, so we need to rely heavily on the expertise of others.
In the world of investing, though, herding is usually quite detrimental to financial returns. And, ironically, the herding impulse is quite strong among investors, who often look to others for confirmation on their investing positions.
Crowds do get a bit of an undeserved bad rap in the investing world – the majority is not always wrong; in fact, the majority is usually right more than wrong. Unfortunately, the herd is usually most wrong at the most inopportune times.
Greedy at Tops, Fearful at Market Lows
A now-famous BusinessWeek cover from the summer of 1979 that proclaimed "The Death of Equities: How inflation is destroying the stock market" reflected the widespread investor pessimism of a grinding bear market in stocks that started 13 years prior.
Unfortunately, for the many investors who were dumping their stock portfolios at this time, a long-term low was just around the corner. Within a year, the Dow Jones Industrial Average (DJIA) bottomed at 763, and then set upon a 20-year epic bull market in which the DJIA increased over 14-fold!
You probably remember the stock mania of 1999 – after two decades of non-stop stock price increases, investors were feeling downright giddy. Companies without earnings, or even revenue, were getting bid up several-fold ... in one day! At the time, the infamous Pets.comsockpuppetwas the darling of CNBC’s airwaves.
Like most stock manias, this one ended in tears. The NASDAQ – usually the poster child of the New Economy’s irrational exuberance – would lose 80 percent of its value over the next couple of years.
Fast forward to March 2009 when stocks saw their worst crash since the Great Depression, with the S&P 500 plummeting over 50% in less than 18 months. NOBODY wanted to own stocks, setting the market up for the greatest rally in stocks since the 1930s.
Why It Pays To Be Contrary
Great investments are often widely hated. When there’s nobody left to sell something, that means it’s probably about time for that something to bottom out. All the bad news has been priced in, so if the economy goes from “bad” to merely “less bad,” there is a good chance you’ll see some healthy price appreciation.
The converse is also true. Wall Street’s darling stocks usually crash the hardest when they fall out of favor with investors. A heaping of good news, combined with rosy prospects for future growth, are already baked into a lofty stock price. If prospects for the company “deteriorate” from “great” to merely “very good,” you could very well see a lot of selling as investors flee to the exits.
Analyst Ratings are Helpful ... As Contrary Indicators!
Companies in the Standard & Poor’s 500 Index that analysts loved the most rose 73 percent on average since the benchmark for U.S. equity started to recover in March 2009, while those with the fewest “buy” recommendations gained 165 percent, according to data compiled by Bloomberg. (Source: Bloomberg)
Legendary investor Peter Lynch summed up the reason for analyst incompetence quite succinctly: "Success is one thing, but it's more important not to look bad if you fail."
Analysts inherently run with the herd. They fear getting left behind and looking foolish if a stock takes off. As a result, they are far more likely to have a Buy or a Strong Buy rating on an equity than they are to have a Sell.
Many fund managers also fall victim to this phenomenon. They chase the hottest stocks at the end of each quarter so that their clients can feel confident their manager has them positioned in the hottest stock; never mind the fact that the gains were to be had before the position was initiated!
“Be Greedy When Others are Fearful”
Warren Buffett, arguably the greatest stock market investor of all time, said it best: A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. (Source: NYTimes.com)
So who are we to argue with a self-made investing billionaire? Evidence shows it, indeed, pays to be contrary!
About the Author
Brett Owens is CEO and Co-Founder of Chrometa, a Sacramento, Calif.-based provider of time management software that accurately records and reports back how you spend your time. Previously marketed to only the legal community, Chrometa is branching out to accounting prospects. Gains include the ability to discover previously undocumented billable time, saving time on billing reconciliation and improving personal productivity. Brett is also a blogger and founder at ContraryInvesting.com, as well as a regular contributor to two leading financial media sites, SeekingAlpha.com and Minyanville.