When it comes to investment decisions, your parents may have given you the best advice: “If everyone else decided to jump off a cliff, would you do the same?”
People tend to follow the herd. We think if the majority is doing something, then it must be the right thing to do. But, there often is little rational justification for following others.
This “bandwagon effect” describes what happens when you decide to do what others do instead of making a reasoned, objective decision on your own.
The bandwagon effect often is used by politicians to influence voters. A study of the 1992 U.S. presidential campaign found that when voters learned that Bill Clinton was in the lead, many who had intended to vote for his opponent, George H.W. Bush, changed their minds and “jumped on the Clinton bandwagon.”
In fact, the phrase “jump on the bandwagon” originated in 19th century America, when several politicians tried to get a seat on a bandwagon used by a famous circus clown. The politicians wanted to be seen in a good light (this was when clowns were popular), and thus seem more appealing to voters.
Just as with voting, investors feel reassured that they are making the right decision when many others do the same. That often occurs when a stock’s price begins to rise. Everyone buys the stock, which influences others to take notice and do the same. Similarly, when a market starts to fall, the investment crowd sells everything because it’s worried about heavy losses. You panic and follow suit.
The bandwagon effect clouds our judgment about specific investments and prevents us from analyzing a stock objectively. Some of the best investment decisions are those that go against the grain. That is what is known as contrarian investing – you buy when the crowd is bearish, and you sell when everyone else is bullish. As we recently discussed, contrarian investing can be risky, but also can result in big returns; or if the timing is wrong, big losses.
One specific type of contrarian investing is known as turnaround investing. It can dramatically reduce the bias of the bandwagon effect. Turnaround investing focuses on what happens when companies announce results. If bad news about a company causes its stock price to plummet, the crowd will “jump on the bandwagon” and sell the stock. That often means the true value of the stock is higher than the current market price. The majority ignore the true value, however, because they are focused on the bad news associated with the company.
Those who spend time analysing the company in detail will note the stock’s higher true value and buy when the price is still low. After the bad news begins to fade from memory, or the masses eventually realise the stock is undervalued, its price will begin to rebound as more people buy it. Obviously, those who bought low are now in a position to sell higher and make a profit.
Several studies have shown that contrarian investors tend to outperform the market. Some of the most successful consider themselves contrarians, such as Paul Tudor Jones, Marc Faber, John Neff and Jim Rogers.
Buying when most people panic, and selling when the bandwagon crowd is certain prices will increase, is hard to do and be successful at, but it is remarkably rewarding in the long term. Avoid being part of the herd. If everyone you know is talking stocks and the newspapers are publishing overly optimistic news, it may be time to consider the contrarian view and be conservative.
As your parents said, just because everyone else is doing it doesn’t mean it is the wise thing to do.