Currently, there are very few places to grow one’s money better than investing in the stock market. And many people who have money to invest are looking for THE top stock pick to get rich, quick! This could be a perfect setup for an investment train wreck. Of course, the extent of the train wreck depends on when one gets onboard and when one jumps off. If you have been on an investment train wreck, you understand that smart people can make disastrous financial decisions.
Why do human beings make irrational decisions – irrational decisions specific to investing?
The concept of ‘herd behavior’ might come to mind. With herd behavior, you are following the crowd; if the crowd makes an irrational decision, you are apt to do the same. Herd behavior can be influenced by fear (including FOMO), uncertainty, or a shared identity of decision-makers (people like me are doing it). Two of the most common irrational financial decisions might be:
- Buying high
- Selling low
Buying high is purchasing shares of company stock, but only after a recent price run-up. It is the act of jumping onto the bandwagon – once everyone else has done so. With respect to the price you pay per share, consider a shopping analogy: buying high is waiting for the sale to be over – and then making your purchase. When you buy high, you’re waiting for demand for the investment to be pushed up, up to a price that is beyond reasonable. In short, you’re overpaying.
Selling low is just the opposite. Selling low means parting with something you already own – but only at a very low price. Selling low is giving yourself a very bad deal, while at the same time giving someone else a really great deal. With selling low, you’re waiting until what you own is out of fashion – at which point you decide, now is the time to sell.
The Why in Herd Behavior
Why would anyone do these financially self-destructive things: buy high and sell low? Behavioral finance says that herd behavior exists because:
- individuals are prone to peer pressure: people conform their investment strategy to what other people are currently doing.
- individuals feel vindicated by the crowd: if everyone is doing it, it is assumed that the strategy practiced universally must be the right strategy.
I believe most of us think we are ‘above’ this behavior, that we use our own information to make independent decisions, yet the study of behavior finance tells us irrational behavior can be contagious if we are unaware and/or unprotected.
Be a Contrarian Investor
Buying low and selling high is contrary to what the lay investor may do – and why the strategy of buying low and selling high could be called contrarian – in investment geek speak. Being a contrarian investor means going against the grain – doing the opposite of what everyone else is doing.
You can be a contrarian investor! You can do this by regularly buying low and selling high. In investment geek-speak, this process is called “rebalancing.” Rebalancing your investment portfolio should be done on a regular basis (usually annually).
Avoid the Train Wreck
Herd behavior can cause a lay investor to make poor financial decisions. But that is where the value of a trusted advisor can help, specifically a fee-only, fiduciary advisor. They can show you a detour around those typical investing mistakes just described: buying high and selling low. They can illuminate the path for you – the path for buying low when others are selling low, and selling high when others are buying high. You have an advisor to call to keep you from boarding an investment train wreck.