There is an inherent problem with following conventional wisdom as an investor. Sometimes thinking outside of the mainstream is the best way to gain a return advantage. There is, of course, comfort in the conventional. There just isn't much profit. Major financial markets are so widely followed and liquid that whatever most people think at any given time tends to affect prices almost immediately. Therefore, to find pricing opportunities, it helps to think a little differently.
Reconsidering the familiarHere are five ways investors can use unconventional thinking to get ahead:
- Embrace market irrationality. To a large extent, modern portfolio theory is based on the notion that financial markets behave rationally, but people who have worked closely with those markets know that this is just not true on a day-to-day basis. Markets may eventually reward value and punish bad businesses, but in the short-term they are driven by rumor, fear, greed, excitement, fatigue and any number of other irrational motivations. The good side of this is that those periods of irrational behavior are what create opportunities -- pricing distortions when a stock or even a broad group of stocks are selling for well below their true value. Taking advantage of market irrationality is what gives you a chance to earn above-average returns.
- Take the news with a grain of salt. The amount of media coverage devoted to the stock market these days is overwhelming, and the producers of that programming feel compelled to fill every minute of that space. Thus, trivial developments are often presented as major news, and some investors react accordingly. Don't rise to the bait. Not every piece of news is a game-changer, no matter how breathlessly it is announced. Get in the habit of putting each piece of news into the perspective of your long-term outlook for the economy and individual companies, rather than viewing it in isolation.
- Look past the CEO. Star CEOs are another creation of the financial media -- personalities make much better copy than balance sheets. In reality though, very few are actually big difference-makers, and those that are tend to be people who had a hand in forming the company, rather than hired guns brought in to save the day. Put your faith in demonstrable competitive advantages, not high-profile hires.
- Avoid the sway of personal preferences. It is a popular notion that if you see a product you like, you could make more by investing in it than by simply buying the product. This may be sound advice in down markets when stocks are generally cheap, but most of the time personal preferences lead to the kind of biases that result in poor investment decisions.
- Go easy on diversification. Diversification is supposed to be another sound piece of investment wisdom. But while most investors know not to put all of their eggs in one basket, investment managers sometimes take this to extremes, owning an enormous number of stocks -- many of which are unlikely to represent exceptional opportunities. Yes, you should spread your money around a bit, but not to the point of watering down your best ideas with a bunch of mediocre ones.