Herd Mentality Investing and How It Affects Your Investment Portfolio
Those of you who have been investing your money for higher returns or retirement for a decade or more are familiar with Sarbanes-Oxley. It was the law passed in 2002 that set rigid standards that were supposed to prevent accounting abuse by large companies to avoid additional scandals and huge losses for shareholders, such as those experienced by Enron and Tyco investors. The validity of Sarbanes-Oxley proved unfounded when we looked at the recent implosion of the real estate and stock market bubble just a few years ago. The failure of these markets was due in large part to new and improved business and investment accounting practices.
As the United States Congress and Senate debate and work to enact new legislation that protects investors even better than before, the investment community is developing new investment products in an attempt to encourage investors to diversify, even if it is in unknown territories. The range of new investment products on offer is very different and it is highly unlikely that new regulations written by government officials to protect investors will cover the accounting practices used to track these new investment products, as Sarbanes-Oxley does not it managed to capture or control those that were critical in the most recent market implosion.
Investment product engineers are introducing new products, such as mortality insurance packages that involve buying large packages of life insurance policies that sick and elderly people are selling for immediate cash, managed futures which is a gamble. complex and risky in commodities and other financial markets, foreign currencies, emerging markets and other exotic investments. Many of these investments are experimental and have not been tested. The average investor should tread lightly and do extensive research before venturing into these exotic new investment fields.
Government legislation and regulation through rigid corporate accounting practices have failed to protect investors in the past and there is no reason to believe that they will be of any help in the future. The best line of defense regarding the best investment strategy is YOU. Past experience has shown that the herd mentality of investing is not strong. As is clear from the lyrics of the song “The Gambler”, “you have to know when to hold them, know when to fold them, know when to walk away and when to run.” The way to do this is to learn to outsmart your brain in order to become a better investor.
Emotions, not logic, generally govern the decision-making of average investors. The investment psychologist and scholars of financial behavior have confirmed this. The best investment options require you to understand and accept your emotions and predilections and determine how to avoid becoming your own worst enemy.
As a habit, humans organize and accept the facts that are provided to them in the form of history. Stories about how someone else used a particular method and reaped benefits will instill in us the feeling of “we can do the same” and we will act accordingly. We tend to look only at those facts that confirm our story. As others repeat the same or a similar story and also act like us, our faith in the story increases. It becomes true and we find safety in it, according to Cass Sunstein, co-author of Nudge: Improving Decisions About Health, Wealth, and Happiness.
It is important that you learn and understand that these mental errors exist and how to prevent them from clouding your investment decision making. If you are a self-managed investor, perhaps you should consider hiring a good investment manager to advise you. You may also want to diversify your portfolio to include a wider variety of investments or use the tried and true investment technique of dollar cost averaging. Invest a fixed amount of money on a regular basis, thus avoiding the temptation to buy high and get involved in risky investment opportunities. The purpose of tricking your brain is to become a better investor and avoid the herd effect of investing. By doing so, you continue to invest for your future and also control your emotional investment decisions.