Why Following The Herd Is Making You a Bad Investor

You probably don’t notice it, but analysts are influencing your stock choices, and you might be losing as a result.

May 25, 2014 at 1:28PM


Source: Flickr / goingslo.

One of the arguments in favor of picking individual stocks is that you can find undervalued opportunities, invest in them, and achieve out-performance.

But what if your choices are being influenced by outside factors that have nothing to do with the stock itself?

The influence of analysts
Stocks are covered by analysts, who write reports based on public filings and offer buy and sell recommendations. Generally speaking, the bigger the company, the greater the coverage, so large cap stocks enjoy much more coverage than small and micro cap stocks. 

Does analyst coverage affect your investment choices? Research indicates that it probably does. 


Source: Flickr / IntangibleArts.

One way to look at the question is to ask what happens when a company loses analyst coverage. A recent paper published in the academic journal The Accounting Review finds that these stocks tend to experience reduced trading volumes, less institutional investor interest, and a widening of bid-ask spreads.

What they don't find is a drop in the companies' economic performance. 

The importance of familiarity
In other words, people lose interest in stocks that aren't getting a lot of attention, and the pricing of these stocks can change as a result -- even if there isn't an investing-based reason for it. 

You've probably heard of Bank of America (NYSE:BAC), which is the most talked-about bank stock. Maybe you even own some shares.

But have you heard of Greene County Bancorp (NASDAQ:GCBC)? Probably not. 

I like Greene County Bancorp primarily because it's in the business of being a bank: Nearly 80% of its income comes from interest, and its noninterest income comes chiefly from straightforward account service charges and debit card fees.

The bank's balance sheet is understandable, which is another advantage over megabanks like Bank of America, which earns only 45% of income from interest and is far from simple.


Source: Flickr / George Pauwels.

Even the Fed can't keep track of the intricacies. 

Whatever your position on these particular banks, it's important to remember that analysts don't necessarily pay attention to good stocks at the expense of bad ones.

It's not an illusion: Even companies going public are highly aware of this. Highly rated analysts can bring in more underwriting business, and there is evidence to suggest that firms actually underprice their IPOs in order to get more attention from top analysts. It's clear analysts routinely pay attention to big and popular stocks at the expense of small and less popular ones. 

Overcoming familiarity
So how do investors take advantage of these things and benefit from mass psychology? There is evidence that unpopular stocks tend to outperform their more popular peers.

In a sample of 1,500 companies, the authors of the book The Psychology of Investing found that surprise "news" -- good or bad -- helped unpopular stocks outperform the market by about 4% per year. Good news generated an enormous 8% outperformance.


Source: Flickr / Tax Credits.

Investing like a Fool
Of course, smaller stocks, which are the least likely to be heavily covered, can be more volatile and more difficult to value than larger ones. Less information can lead to less accuracy and more risk.

Aswath Damodaran, a professor at the NYU Stern School of Business, recommends three strategies: First, focus on diversifying across stocks. Second, don't forget to do your due diligence -- research and a clear head will serve you well. And third, be patient by keep a long time horizon.

Remember, the easiest way to fix a psychological quirk is to become familiar with it.

If you're pouring over Bank of America just because you're hearing about it all the time, then maybe next time you'll stop yourself and start investigating some of the other banks that don't get so much attention. 

Big banking's little $20.8 trillion secret
There's a brand-new company that's revolutionizing banking, and is poised to kill the hated traditional brick-and-mortar banks. That's bad for them, but great for investors. And amazingly, despite its rapid growth, this company is still flying under the radar of Wall Street. To learn about about this company, click here to access our new special free report.

Anna Wroblewska has no position in any stocks mentioned. The Motley Fool recommends Bank of America. The Motley Fool owns shares of Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

4 in 5 Americans Are Ignoring Buffett's Warning

Don't be one of them.

Jun 12, 2015 at 5:01PM

Admitting fear is difficult.

So you can imagine how shocked I was to find out Warren Buffett recently told a select number of investors about the cutting-edge technology that's keeping him awake at night.

This past May, The Motley Fool sent 8 of its best stock analysts to Omaha, Nebraska to attend the Berkshire Hathaway annual shareholder meeting. CEO Warren Buffett and Vice Chairman Charlie Munger fielded questions for nearly 6 hours.
The catch was: Attendees weren't allowed to record any of it. No audio. No video. 

Our team of analysts wrote down every single word Buffett and Munger uttered. Over 16,000 words. But only two words stood out to me as I read the detailed transcript of the event: "Real threat."

That's how Buffett responded when asked about this emerging market that is already expected to be worth more than $2 trillion in the U.S. alone. Google has already put some of its best engineers behind the technology powering this trend. 

The amazing thing is, while Buffett may be nervous, the rest of us can invest in this new industry BEFORE the old money realizes what hit them.

KPMG advises we're "on the cusp of revolutionary change" coming much "sooner than you think."

Even one legendary MIT professor had to recant his position that the technology was "beyond the capability of computer science." (He recently confessed to The Wall Street Journal that he's now a believer and amazed "how quickly this technology caught on.")

Yet according to one J.D. Power and Associates survey, only 1 in 5 Americans are even interested in this technology, much less ready to invest in it. Needless to say, you haven't missed your window of opportunity. 

Think about how many amazing technologies you've watched soar to new heights while you kick yourself thinking, "I knew about that technology before everyone was talking about it, but I just sat on my hands." 

Don't let that happen again. This time, it should be your family telling you, "I can't believe you knew about and invested in that technology so early on."

That's why I hope you take just a few minutes to access the exclusive research our team of analysts has put together on this industry and the one stock positioned to capitalize on this major shift.

Click here to learn about this incredible technology before Buffett stops being scared and starts buying!

David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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