Most Investors follow the crowd down the path to comfortable mediocrity. – David F. Swensen
Somewhere (I am not saying where) there is a picture of me at a high school dance, circa 1980. My hair is longish and parted in the middle. I am wearing a powder blue polyester suit with airplane wing collars and bell-bottom pants. Platform shoes and a ridiculously wide tie complete the ensemble.
Yes, it is as bad as it sounds. Probably worse. My excuse? That’s what everyone was wearing. I was just following the crowd and trying to fit in.
The Consequences of Following the Crowd in Investing
Following the crowd in fashion can lead to some embarrassing photos, but following the crowd in investing can have much more serious consequences.
Morningstar conducts studies on how money flows into and out of the financial markets. These studies consistently show that more money flows into markets when prices are high and out of markets when prices are low, the exact opposite of what rational investors attempt to do. This irrational behavior can be explained the same way as our past fashion mistakes – by our innate human need to fit in and be part of the crowd.
Morningstar puts the negative consequences of this irrational investment behavior at 1.5 percentage points per year for the average investor. This is similar to the fee many financial advisors charge, but in this case investors impose the fee on themselves through their behavior.
1.5 percentage points might not seem like a lot but you ignore it at great peril to your financial future. Jordan Ellenberg, author of How Not to Be Wrong: The Power of Mathematical Thinking, writes about how even small changes in investment performance can become big over time. Ellenberg states, “Expenses add up – or, more mathematically precisely, they multiply up.”
How much do expenses “multiply up?” Assuming a 6% after-inflation investment return, $100,000 would become almost $1.1 million after 40 years ($1,095,745). If irrational behavior from following the crowd cost you the 1.5 percentage points per year that Morningstar estimates, that same $100,000 would be worth just over $600,000 ($602,932) after 40 years, a difference of almost a half million dollars. That is a steep price indeed to pay for the comfort of following the crowd.
Fear, Greed, Courage, and Contrarian Investing
You can avoid this self-imposed following-the-crowd fee by having the courage to be a contrarian investor. This entails, in the words of financial writer David F. Swenson, “…shunning the loved and embracing the unloved.” Being a contrarian involves going against the crowd and standing alone at times. When everyone else is buying you temper your enthusiasm. When everyone else is selling you take advantage of the lower prices by buying.
Warren Buffett, perhaps the most famous and well-known investor of our time, attributes much of his success to being a contrarian. In what I consider one of the smartest and most memorable things ever said about investing, Buffett, after explaining that markets are largely controlled by fear and greed, attributed his success to attempting to “…be fearful when others are greedy and greedy when others are fearful.”
Separate Knowledge from Behavior
Reid Hoffman, co-founder of LinkedIn, reminds us that being a contrarian investor, by itself, is not enough. In his book The Start-up of You, Hoffman states, “In public market investing, as in many things, you achieve big success when you’re both contrarian and right.” In other words, the formula for successful investing is:
Contrarian Behavior + Being Right (Knowledge) = Investing Success
Buffett didn’t become one of the richest people on earth simply by being a contrarian, but by being incredibly skillful at identifying undervalued companies. Throughout his career Buffett has been both contrarian and right most of the time.
Since Buffett’s stock picking skills are impossible for most of us to replicate, can we still profit from being a contrarian investor? I believe the answer is “yes.” While we certainly can’t achieve Buffett’s level of success we can become successful investors by separating the knowledge part of the equation, or being “right,” from the contrarian or behavioral part of the equation.
I can’t pick stocks like Buffett, but I can look back at stock market history and identify underlying patterns. The first pattern is that, in the short-term, the market is volatile and unpredictable. The second pattern is that, in the long-term, the stock market rises faster than other asset classes.
The short-term pattern gives you opportunities – betting on the market as a whole using low-cost index funds – to be “fearful when others are greedy and greedy when others are fearful.” The long-term pattern allows you – by betting on the market to ultimately rise – to eventually be “right.” This won’t create quick and spectacular success, like Buffett’s, but it can allow you to beat most other investors over time.
I am a simple man, and thinking of investing like this makes things easier for me. I believe behavior is more important than knowledge in investing, but if I am constantly worried about whether I am right or wrong it is harder for me to control my behavior. Using low-cost index funds and betting on the stock market to go up in the long-term allows me to separate the knowledge part of the equation from the behavior part of the equation, and to focus most of my effort and attention on controlling my behavior.
In my next post I will write about five foolproof strategies to make money following Buffett’s advice to be “fearful when others are greedy, and greedy when others are fearful.” Stay tuned.