Five Ways to Avoid Herd Investing

Understanding the herd mentality will keep you from chasing bubbles.
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If you want to make money investing, one of the most important rules is

to avoid following the herd when the numbers don't support the hype.

One sign a "herd" mentality has taken over investors is when people proclaim that old, tested investing models no longer apply and use generalities to describe what's going on in the market instead of relying on hard data.

Excessive interest in sometimes risky investments due to insecurity that one might miss out on a hot stock or fund is one of the key ingredients in investment bubbles, according to a July 2006

study by Peter DeMarzo and Ilan Kremer of the Stanford Graduate School of Business, along with Ron Kaniel of Duke University's Fuqua School of Business.

If you have ever wondered why people continue to invest even when it becomes obvious that a stock or fund is risky and a bubble is forming, the study finds that it isn't so much that people believe that they are buying into a good investment, but simply that they are afraid that others will make money on the investment and they won't. According to the study, many people fear being left out of the possible rewards from the investment much more than they fear actual risks.

The traditional economic assumption is that an investor's main desire is to maximize his or her wealth. But the study finds that this view is an oversimplification for what happens in the real world. When it comes to someone's actual investment decisions, rational thought takes a back seat to what the peer group is doing. In other words, your desire to keep up with the Joneses overrides the risk of the investment. You fear that the Joneses will make money on the investment and you won't, even when the investment fundamentals say that it is high risk.

According to the study, the herd mentality arises when people directly compete for scarce resources. DeMarzo says communities with tight real estate markets and a limited labor supply for services, such as in the Bay Area or Manhattan, are "natural examples of where community herding competition can take place."

"This same competition emerges within age cohorts, such as middle-aged individuals 'competing for' investment vehicles to save for retirement," he says.

Investment herding especially manifests itself around high-tech investments, which people feel may revolutionize the market. In these areas, there is high potential gain, but also high risk.

Herding helps explain how stock bubbles arise when standard economic models say that they shouldn't. When investors begin to herd into a particular stock, the price of that stock skyrockets. In this case, rational investors should stay away from the overpriced stock, but they don't. Even when it's apparent that the stock price is too high for its fundamentals, the fear of missing out makes people invest until the bubble bursts.

For those who want to avoid herd investing, here are five simple steps to take:

1. Understand why it happens

: By understanding that herd investing occurs not because of some secret that everyone but you is aware of, but because of other people's fears, you are in a much better position to resist the temptation of the herd.

2. Ignore the crowd

: This is easier said than done, but when everyone begins to say the same thing that goes against the investing fundamentals, it's time to trust your own instinct and ignore the crowd. When you hear people talking about how great an investment is without actually saying anything about the fundamentals, you know it's time to walk the other way.

3. Step back and look at it rationally

: If everyone is rushing into a certain investment, that's a pretty good sign that it's not in your financial interest to join the crowd. Take the time to research the fundamentals and see if it makes sense on its merits and not because everyone is cheerleading. As DeMarzo notes, "Investment and prices may be distorted significantly from fundamentals as a result of this herding behavior."

4. Become the peer leader

: It is much better to be at the front of the herd than in the main pack behind. If you invest as a leader of your peer group, much like the "first adopters" of new technology, you have a much better chance to profit from your investments than those that are in the pack behind.

5. Look out for business herding

: While evaluating investments for your portfolio, in addition to avoiding investments that the herd is clamoring for, be wary of companies that may be exhibiting the same signs. For example, telecommunications companies showed this mentality when they overinvested in fiber optics in the late 1990s. After the bubble burst in 2003, fiber-optic networks had fallen by more than 90%.

Just as important as knowing the personal finance and investing fundamentals to grow your money is knowing the common pitfalls that can erase all your hard investing work. By understanding why herd investing takes place and avoiding it by investing with a long-term plan, you will be in a much better position to avoid investment bubbles as they arise.

Jeffrey Strain has been a freelance personal finance writer for the past 10 years helping people save money and get their finances in order. He currently owns and runs SavingAdvice.com.