Investors: Be Wary of Herd Mentality

Smart asset allocation and timely rebalancing helps investors avoid falling prey to herd mentality.

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It appears the Delphinian oracles have emerged from the modern day temple of Apollo—Wall Street—to share their wisdom. What is their sage advice? Sell your stocks and hunker down in a more defensive position.

The numbers are in: employment growth is down, housing prices are down, manufacturing is down, we have debt problems at home, and there are debt problems abroad. The financial pundits have come forth to offer their counsel, and like well-behaved cattle, the mooing masses have left their fair pasture and are being herded through the rancher's gate to some unknown but new destination.

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The herd mentality is well researched and highly documented. It is easily seen in investing through the cyclical frenzied buying (bubbles) and frantic selling (crashes) of the stock market. These sudden swings are rooted in irrational investing practices and driven by emotion—greed in bubbles and fear in crashes.

New economic data is acted upon within seconds by portfolio managers armed with cutting edge rapid-response technology. These "in-the-know" active managers move the market. The media then reports. Articles grace the front page of national publications and prime-time television. Jim Cramer starts banging and bonking his toys while he yells out "sell, sell, sell," and the frenzy is afoot.

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Our current market is characterized by plenty of mooing these days. Six straight weeks of market losses have not been seen since 2002, and have pushed the Dow Jones Industrial average below 12,000 after an exuberant eight-month run in which corporate profits and share prices soared. Just when retirement accounts of ordinary Americans began to look healthy again, bang—we are thrust back into dark times.

And boy, does this type of news preach! This is when the herd really gets moving. Investment advisers are inundated with bleating customers asking to be moved into defensive positions. With herd-like agility, these investors have a knack for timing the lows with perfect precision. Never mind the fact that the system is rigged to slaughter the slow moving cattle that seem to always make their move a bit too late. Still, year after year, these retail investors are easily rounded up for the slaughter by the pros that know how to make a real profit.

Investors forget that stocks do not rise steadily over time. They do so in a rather abrupt series of fits and starts with a few days of large gains sprinkled randomly throughout the year. According to finance professor H. Nejat Seyan, if you missed the 90 best-performing trading days from 1963 to 2004, your annual returns plummet from 11 percent to 3 percent. Indeed, you would need to be an oracle to accurately pick the 90 best days out of 14,694!

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Suffering from collective irrationality, these investors are like sheep without a shepherd, lacking any sense of long-range vision and guiding principles to anchor their portfolio management. They are unsheltered, exposed, and ready to become prey. They are ships without moorings. Their portfolios are tossed to and fro in the market's choppy seas.

The first lesson of Wall Street is to exploit mass-market psychology by acting in a contrarian fashion. Studies by economists and psychologists have found that investors are most influenced by recent events—market news, political events, earnings—and ignore long-term investment and economic fundamentals.

As a retirement investor, you have a few clear and simple choices. You can enter the active management fray and compete with the big dogs, you can follow the masses and fall prey to the bloodletting, or you can rise above it all by rooting your investment philosophy in proven science and long-range planning. Buy low-cost funds, embrace basic global asset allocation, and rebalance your best-performing assets with some of your worst-performing ones. In turn, you can rule your portfolio with long range and academically proven principles, and invest effectively with peace of mind.

Steve Beck is cofounder of MarketRiders, an online investment advisory and management service helping Americans invest for retirement. MarketRiders gives investors greater peace of mind knowing that they are leveraging the best thinking of Nobel laureates and the investing methods used by the world's most elite institutions and wealthiest families. MarketRiders is on the investor's side, helping reduce investment costs and risks, and increasing retirement savings.