Why running with the herd can damage your wealth

The art of making a profit is a fairly simple affair in theory. You buy something at a one price, add value to it in some form, and then sell it at a higher price.

When investing, the same premise applies. The difference is that the price of the assets, normally shares, can go up and down of their own accord. The value that you add is in the timing of the buying and selling. Most people would agree that the basic foundation of achieving growth in your investments is to buy when prices are low, and then sell when the price is high. Easy, job done.

Well, no not really. Our human nature is programmed to make us want to do exactly the opposite and can be demonstrated by looking at just about every economic crisis in history.

In 1929 the Stock market had been rising for many years due to technological improvements in the trading system. This in turn had allowed normal people to access the stock market in a way previously unknown. The market rode on a wave of enthusiasm, optimism and unswerving belief that it only ever went up.

There’s a great story about Joe Kennedy, JFK’s father, who was a prolific stock market investor in the 1920’s and 30’s. Shortly before the crash Joe Kennedy sold every one of his shares. At the time this must have looked like one of the biggest misjudgments since Eve decided she was a bit peckish. When later asked why he had sold his entire holding he replied that on the way to work that day he had been given some share tips by his Shoeshine Boy. It was at that moment that he decided the market was so overvalued that a crash was inevitable and marched into his office to tell his crestfallen broker to sell.

The point is that as the share prices had risen in the previous years, more and more people had bought into the market at an ever-higher price. When the crash came, everybody wanted to sell which forced the price down and then they wanted to sell even more. The direct opposite of the basic principle that seemed to make so much sense a moment ago.

This is all down to our basic human nature which promotes conformity. We take comfort in the actions of others. If we are unsure about something then we look to see if other people are doing the same thing. The more that are, then the safer we feel in doing it ourselves. Basically we don’t like to run against the herd.

But we don’t need to go back to 1929 to see evidence of this. As you may have noticed, there have been a few problems with the economy recently. Consequently the FTSE has dropped by around 35% in the last two years, although it has seen a bit of a rally recently.

When Woolworths had a closing down sale and offered a 25% discount on Pick’n’ Mix there were near riots. In fact on the news reports one elderly lady was seen executing a near perfect half nelson on another unsuspecting shopper who had the misfortune to position themselves between her and the Liquorice Allsorts.

Yet when shares are available for a third less than they were, there is no such violent frenzy for FTSE tracker funds. In fact the main temptation with investors is to sell or move into something ‘a bit safer’ until prices rise and then start buying again.

Ironically the market needs these investors otherwise those who buy when it is low and sell when it is high, would have no-one to buy from and sell to. So the next time the herd is choosing which direction to go you may just want to consider turning left when they turn right.