The Crowd is Generally Wrong

The Crowd is Generally Wrong

by Thomas L. Hardin, CMT, CFP

Instead of understanding the fundamentals of portfolio management and the rules for smart investing, many people look to "the crowd" for investment advice. When the crowd agrees that the market's going up, they jump in. When the crowd thinks the market's going down, they're ready to jump out. Unfortunately, the crowd is almost always wrong. Markets tend to move opposite of what the majority of people think.

By the time everyone believes the market is going up, there are no buyers left to support the market's upward movement. That causes the trend to stall, and a new countertrend begins. As people with high expectations of making money start losing money, crowd psychology takes over again.

The stronger your gut feeling is, the more likely you are to be wrong. Bull markets "crawl a wall of worry" - when people are the most worried, the market starts to go up, not down. But when the crowd agrees that "We're in the new paradigm" and "It's different this time,"it's a sign that you're at the top or bottom of a market, depending on which way the market's leaning.

Crowd psychology occurs at extreme valuations of the market, both high and low. Sharp advances bring about sharp declines and vice versa. The truth is, the crowd tends to be correct in the middle part of a trend but wrong at the major turning points, which is where much of the money is made or lost.

In late 1999, I remember counseling a client who was very concerned about the potential impact of Y2K. He, like many other people at that time, believed all the computers would stop working on January 1, 2000, and, in anticipation, the market would go down. Following this crowd psychology, many investors got out of the market in the third quarter of 1999.

How did the market react to this doom and gloom? During the fourth quarter, when the majority of people expected the market to go down, the S&P 500 actually went up 15%. Almost all the money made in 1999 was made in the fourth quarter. When Y2K passed and nothing happened, the majority of investors were bullish. They thought the market, particularly technology and Internet stocks, would continue to go up. People said, "We're in a new paradigm, a new economy. Forget about valuations. It's different this time." Investors learned to buy dips in the market (they bought more every time the market declined). After all, it had always worked before. But as the old saying goes, once you think you've figured the key to the market, someone will always change the lock. While the crowd insisted that the market would keep going up in 2000, it became obvious that the end was near. We soon found ourselves in the worst market since the 1930s.

Here's a more recent example of crowd psychology gone wrong. In mid-March 2003, after three years of the worst bear market in our generation's memory, people were pessimistic. The war with Iraq didn't seem to be going well, the economy wasn't good, and oilfields could be blown up at any moment, throwing our economy into a panic. Conventional thinking expected the market to drop. But from that time to the present, the Dow has risen from 7,500 to 9,000.

Rather than listening to crowd psychology and constantly changing their investment policies, smart investors use a rules-based process for managing their money, a system that helps limit emotional reactions to major events. Even though market returns may be erratic in the short term, the smart investor knows returns are fairly predictable over a longer period of time and stays in for the long term. Smart investors know that even if they're over 50, they're in their "second 50 years" and have plenty of time to ride out market cycles.

Smart investors don't let market volatility force them into rash decisions. They realize that following the crowd psychology, with its basis in the human emotions of fear and greed, can wreak havoc on their long-term investment program and prevent them from making their second 50 years the best years yet. To be a smart investor, don't fall into the traps of buying high and selling low. Don't change your investment strategy by getting out when you feel concerned and reinvesting when you feel confident. Try to remove feelings and emotion from your investment program. Remember that major shifts in asset allocation can destroy a long-term investment program, and follow a rules-based portfolio management system, a process you can believe in. If you need assistance setting up such a system, the professionals at Canterbury Financial Group will be happy to help. Then, once your system is in place, sit back, relax, and leave the crowd mentality to the uninformed.