Just like buffalo people often feel safer in herds. In most situations this is not a problem, but in some instances (like investing) herds of people act more like lemmings than buffalo, which can land you in serious financial difficulty. Here’s why.
Ignoring Fundamental Analysis could Equal a Harmful Investment
When looking at a potential portfolio, there are two types of analysis “Technical Analysis” and “Fundamental Analysis”. a relatively safe method of judging its success at market is to view its statistical performance history.
Technical Analysis involves examining trends and patterns in the stock’s charts and making predictions regarding how it will perform in the future. A chart that looks like a rocket taking off indicates the herd is already on board and you need to exercise caution.
Fundamental analysis involves looking at this like P/E or Price Earnings Ratios, Liquidity ratios which measure the availability of cash to pay debt, Debt ratios which measure the firm’s ability to repay long-term debt, and Profitability ratios which measure the firm’s use of its assets and control of its expenses to generate an acceptable rate of return. By looking at these ratios and comparing them to historical averages you can determine if a stock is overpriced and avoid the herd mentality.
Following the Crowd can Lead to Getting Trapped in a Bursting Bubble
As with the collapse of the US housing market in 2008- 2010, investment bubbles can be incredibly damaging to your financial health. Following the herd in the early stages of a Bull Market (momentum investing) can prove profitable as long as you get out before the top.
“When the guy bagging your groceries is talking about the Stock Market it is time to get out.”
Thinking critically and individually about the investment value of a mortgage could have prevented the mortgage rate inflation we saw through the 21st century. Even today in the UK, the news is that mortgage deposits are at their highest ever point- roughly 10% on average.
The UK government’s new plan to introduce 95% mortgages is arguably a reactionary response to the hike in deposit prices. However, it in itself could lead to a second housing bubble. So beware, and don’t get trapped inside an investment which is likely to burst.
Following Markets Prevents you from Achieving Real Success
According to legendary investor Bernard Baruch, economic advisor to Woodrow Wilson and Franklin Roosevelt, you should never follow the market exactly. This is simply because following the market will mean that you will never get out ahead of it and make any serious profit.
Furthermore, by following the crowd, you’ll make all of the same mistakes as everybody else. It therefore pays to try alternative strategies, and to be innovative: be a leader, not a follower.
Ignore Irrational Advice and Strike while the Iron’s Hot
“Chance favors the prepared”
Finally, when you spot a good investment, go for it. Don’t let the fact that other people are ignorant of it bother you. Similarly, avoid letting your current financial situation stand in your way of buying shares. The window of opportunity for a good investment is generally fairly short, so ensure you have accessible funds. This is often referred to as “keeping your powder dry”. The alternative is taking out a short-term loan or using some other form of leverage such as “margin” which increases your risk but can also multiply your profits if you judge correctly.
Ultimately, if you’ve done your homework, don’t let other people’s advice and decisions deter you from what you know is a legitimate safe and sensible investment. When it’s time for you to invest, don’t let the herd drag you along or deter you.
Photo Credit: Animated sequence of a buffalo (American bison) galloping. Photos taken by Eadweard Muybridge (died 1904), first published in 1887 at Philadelphia (Animal Locomotion). Animation by Waugsberg, 2006-7-16.