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The Dangers of Investing With the Herd

Since March 2009, we've watched the market rebound, even breaking new records in recent weeks. Now, whether you've sat it out on the sidelines or think you can predict what comes next, I recommend you take a step back and remember a few things.

1. You are not as smart as you think.
Overconfidence is a huge behavior problem for investors. Overconfidence is what happens precisely because we think we know a lot about the subject, but overconfidence can lead us to make mistakes that in hindsight will be glaringly obvious (but the tricky part is that we didn't know it at the time).

2. Following the herd doesn't make it safe.
I know it's exciting and fun to be an investor in the latest hot stock. Then there's the talk about getting access to private IPOs (like when Facebook was available through Goldman Sachs). Buying because everyone else is buying is not an investment strategy. These companies may be great investments, but not just because everyone else is buying their stock.

We're social animals who feel safer in numbers, but so do sheep. We take comfort in doing what everyone else is doing, and in the back of our minds we know that even if we're wrong, at least we'll be wrong with a bunch of other people. But it was the same line of thinking that led us to do very stupid things in high school just because "everyone else was doing it."

3. Investing is about behavior, not skill.
Maybe you'll accuse me of beating a dead horse, but successful investing is about how you behave. Buying high and selling low is dumb, but it's worth repeating given what I'm seeing in the market today. It's important to remember that you could own a "mediocre" mutual fund, and if you behave correctly you can outperform 99% of your neighbors. On the other hand, if you spend your whole life searching for the "best" investment, you'll ruin your entire lifetime return in one single behavioral mistake.

I know that what I've outlined sounds obvious and easy to scoff at, but the fact that it's obvious didn't keep investors from loading up on tech stocks in the late 1990s, bonds in 2002, and real estate in 2006. As the market continues to rise and fall, please remember that it's worth taking the time to stop and think before you invest.

A version of this post appeared previously at The New York Times.

Carl Richards is a financial planner and the director of investor education for the BAM ALLIANCE, a community of more than 130 independent wealth management firms throughout the United States. Visit Behavior Gap for more of Carl's sketches and writings. Carl doesn't own shares of any companies mentioned.

The Motley Fool recommends Facebook and Goldman Sachs. The Motley Fool owns shares of Facebook and has a disclosure policy.

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  • Report this Comment On May 15, 2013, at 10:15 AM, Mega wrote:

    Bonds were a pretty good investment in 2002. Compared to tech stocks in 1999 and real estate in 2006 they were fantastic.

  • Report this Comment On May 15, 2013, at 2:57 PM, HectorLemans wrote:

    ^Just FYI on the bonds - I've been running an investment fund for 2-1/2 years whose performance I measure against stocks (VTI) and bonds (BLV). Bonds returned 23% in 2011 while stocks returned just over 1%, but guess what? To-date, stocks are beating bonds quite handily at 35% versus 24%. Talk about following the crowd... it was extremely tempting to rush into bonds after that 23% return-year, but if I had I would have gotten crushed on returns over the long haul.

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