Mental Money Mistake 4:

This is the fourth letter in a series titled “Mental Money Mistakes.” What are mental money mistakes? They’re subtle errors in judgement. Basic oversights and miscalculations. As a rule, they tend to be subtle and easy to miss. I don’t mean big mistakes like taking on a bunch of debt, spending more than you can afford, or being too risky with your investments. No, these are the kinds of mistakes just about anyone can make, even if you’re intelligent and hard-working.

Today, we will discuss:

Mental Money Mistake #4: Following the Crowd

“Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.”
– Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds

You’ve probably heard of the phrase “buy low and sell high.” In a nutshell, it means buying a stock when the price is low and likely to rise in value, and then sell when it’s reached it’s peak but before it starts to fall.

Unfortunately, many investors do the opposite—they “buy high and sell low.” They don’t do it on purpose, of course. They do it because they follow the crowd. Let’s take a fictional company as an example. Imagine that the ACME Corporation (of Looney Tunes™ fame) has just announced a new product to help wily coyotes catch incalcitrant road runners. This excites investors and analysts both, who promptly decide to buy the stock. The stock price rises. More investors jump in. The stock price rises faster. Suddenly you start hearing news stories about how ACME is a “must buy!” or that it’s “the hottest stock in decades!” Even your friends all talk about how many shares they’ve purchased. And since the stock just keeps going up, you decide it’s too great an opportunity to miss.

In reality, though, the opportunity is likely to have already passed. Suddenly, you’re buying stock at an absurdly high price. So much for buying low. Worse, you’re buying the stock not because you or your advisor did any research on the subject. You’re buying it because that’s what everyone else was doing, and you didn’t want to get left behind.

A few weeks go by. Maybe a few months. Then one day you turn on the TV and learn that ACME’s new roadrunner catcher doesn’t work nearly as well as people thought. In fact, at least one coyote has died—blown himself up, in fact.

Sell, sell, sell.

Since most investors now want nothing to do with the stock, you’ll likely have to sell your shares at a much lower price than you bought them for. And before you know it, you’ve lost money.

That’s what following the crowd can get you.

Now, most savvy investors know this already, and they do a good job of avoiding simple “hot stocks.” But that doesn’t mean they’re immune to making this mental mistake. Let’s take the above example and apply it to something bigger. For example:

  • During times of market volatility, following the crowd and getting spooked by the markets altogether … and then missing out on the inevitable rally that comes later.
  • Buying/investing in a commodity because that’s what the crowd is doing—like gold or real estate (this has happened on many occasions over the past decade).
  • Taking out a second mortgage or engaging in some other type of fancy financial tactics because that’s what everyone else in the neighborhood, church, club, or company is doing.

The point is, that following the crowd is easy, even if you are an otherwise smart, savvy individual. It’s so easy to be caught up in emotion. So easy to let yourself be influenced by “the madness of crowds.”

To avoid making this mental mistake, follow these easy steps:

  1. Remember that if something sounds too good to be true, it always is.
  2. Whenever an exciting investment idea comes to you, give yourself a few days before taking any action (if possible). Then, when you return to the idea, you can examine whether it still seems as promising as it did before.
  3. Write out a list of investing/financial rules for yourself, like a “Ten Commandments” list for your personal use. An example: I will never discuss my investments with my friends, nor listen to them discuss theirs.
  4. Always get a second opinion from an independent, unbiased financial professional before making a major financial decision.

Keep an eye out for next month’s letter, where we’ll discuss Mental Money Mistake #5: Pride Goeth Before the Fall.