Dangers of jumping on a bandwagonBefore you jump on the copycat bandwagon, it's handy to understand the pitfalls of this approach to investing.
It’s a famous old adage that investors are driven primarily by fear and greed. When news turns bad, our fear that it will get worse leads to panic selling, often followed by missing the boat when the market bounces. Greed is another example of the herd instinct overwhelming our rational thoughts. Here are two common situations where greed affects our ability to make sound investment decisions.
Markets move in cycles but the timing of these is largely unpredictable. Academic evidence suggests that attempts to profit from market timing are likely to be futile. The media only reports when there are extreme movements in markets, such as hitting a record high/low or moving more rapidly than normal; newspapers do not report ‘boring’ steady performance. Expect to read stories picking out examples of huge gains made by a select few stocks accompanied by adverts from product providers urging you to jump on board this apparently unstoppable gravy train. However, this is exactly when alarm bells should be ringing. Instead of taking more risk, now might be time to take less. Or just ignore the hype and do nothing.
Another situation will be an offer to invest in a product that appears to have an extraordinarily strong performance record. In most walks of life past performance does give a pretty good guide to the future but in the case of investment it really doesn’t work at all. The main reason is that there is a tremendous amount of ‘noise’ in the data. As the time period lengthens, the ratio of noise to facts reduces but only slowly.
One explanation for a strong recent performance record can be that this style of investment is in fashion. When a style is working everyone using this strategy will profit (regardless of skill) and the opposite is true. A common example would be just to invest in ‘boring’ companies paying large dividends and with good cashflow. This is an entirely sensible approach but there will regularly be periods when it isn’t very profitable. Just like hemlines, investment fashions change. So, if this style is being actively promoted it probably means that it‘s already well into a phase of outperformance and sooner or later that will come to an end.
EQ tip: in the investment world ‘boring’ is often the safe option, herds are rarely right.