My experience counseling investors over the years has led me to believe that our minds are designed to make us fail as investors. This doesn’t mean that we can’t succeed. It just means that to be successful, we need to work past the impulsive and irrational thoughts that enter our minds, and calmly make our decisions based on objective thought processes.
That is easier said than done, and unfortunately it is not even said to most investors. In most other aspects of our lives, we make pretty good decisions that have served us well, and lead us to believe it will be the same for investing. However, without guidance from an objective advisor, the vast majority of personal investors get their information from sources that mix advice with entertainment, and they make impulsive and irrational decisions based purely on emotion.
In the world of capital markets, which is a social science, similar decisions made by many people make an impact in pricing, and can change the situation for others. For example, if a large group of people buy stock in a tech company that makes gizmos people just can’t live without, the price of that stock will go up. A rational person would say that a higher stock price means less of a bargain, and not as good of a value. Many other impulsive investors might think that this must be a good investment because it has gone up in price recently. They would buy shares and drive the price up further. This cycle would continue until the entire herd has purchased the stock, at which point the stock would be well overvalued in relationship to its earnings and assets.
The herd that acts on their own emotions by following the choices of others, rather than using their own reasoning abilities, will often end up being in the wrong place at the wrong time. The herd ran to technology stocks in 1999, real estate in 2005, oil in 2007, and gold in 2011. The herd ran out of stocks in 2003 and 2009. Studying the herd can not only serve as a warning of what not to do, it may be a powerful predictor towards choosing to do the opposite.