In my last post, I showed how the average investor made a dismal 3.7 percent annualized return over a 20 year period—from 1985 to 2005—when the S&P 500 had annual returns of 11.9 percent! And the culprit for the poor performance … good ‘ole human emotion.
So lets take this one step further. What happens when you add one investor’s emotions to the emotions of thousands and thousand of other investors? You end up with classic crowd behavior. And its poster child—Wall Street.
Research on crowd behavior shows a primitive tool for survival is the desire to seek signals from other individuals within a group. We do this in order to align our feelings and convictions. Said differently, most individuals find more comfort in a group as no one really likes to “go it alone”, or “swim upstream” so to speak.
But this is exactly why the classic crowd behavior on Wall Street can crush the average investor’s returns. The market optimism and pessimism of the crowd begins to substitute for a lack of rigorous reasoning and analysis. External signals now come into “the group” and are filtered collectively.
The tendency for “group think” in the financial markets is not just common: it’s ubiquitous. Most investors—including professionals—get their financial information from the same sources: CNBC, newspapers, tipsters, and analyst. Then the investment mind unconsciously says … there is not enough “other” information to rely on for reasoning; therefore I must rely upon the herd.
And the stronger the mood of the crowd—the stronger the crowd’s convictions—and the more inventive its rationalizations. How else could companies with no revenue—let alone earnings—get priced into the stratosphere during the dot.com bubble.
I can remember one instance in 2005 where an investor my firm was working with came to us and said “I know this person who keeps buying and selling condos and he’s making a killing”, and he further went on to request a large withdrawal from his account so that he could get “into the game” that all his friends were playing.
The transaction made little sense and actually jeopardized a otherwise very sound retirement plan that had been carefully crafted over several years. Despite our pleas, the investor proceeded to jump in…just as the market was peaking.
As it turrned out, south Florida became one of the most overbuilt areas in the country—thanks to investors who thought they could not miss.
Sometimes, even people who would normally know better, succumb to the pressure of their peers and the crowd.
Keep checking back for my updates here at Equities.com. In the coming weeks I will be breaking down small cap equity plays and “systematic” hedges you can use to profit. We can then let the “crowd” do whatever it wants—while we remove the emotions and let the systems do the work.
You can also learn more about systematic investing at the Porfolio Café.
Also don’t forget to leave a comment or question—I welcome the dialogue on ways to profit outside of the herd!