If you know your principles of influence, then you know that once I tell you the stocks that everybody has been buying over the past year, you're going to feel the need to go out and buy them for yourself. This phenomenon is called "social proof," and it's effective because when faced with limited information, people tend to choose what other people are choosing.
In some circumstances, this is quite helpful. Let's say, for example, you're at a new restaurant and are trying to figure out what to eat. If everyone around you is ordering the chicken and gravy, then it's likely a safe bet that the chicken and gravy tastes pretty good.
But it's not always gravy
When it comes to investing, however, social proof is your enemy. Looking back on the tech bubble, James Grant wrote in The New York Times, "The unbearable sight of a neighbor getting rich in the stock market in the late 1990s made millions of Americans bipolar." It was social proof, in other words, that led investors to speculate on technology stocks such as CA
Similarly, social proof was one of the forces behind the housing bubble. Folks who watched television shows such as Flip This House or Flipping Out saw how much money was being made in real estate and wanted to try it themselves. Perhaps more amazingly, banks -- subject to the same social pressures -- let them!
For evidence of that, check out Michael Lewis' account of the debacle that took place at AIG Financial Products. AIGFP justified its reckless purchases of credit default swaps by seeking out the opinions of banks like Goldman Sachs. But few uncovered the truth about the housing bubble before it burst. Rather, faced with limited information, they all copied their peers.
When it comes to money, that's a problem
When it comes to investing, if everybody is buying the same asset, the price of that asset will increase. As the price of an asset increases, its expected rate of return decreases. Take this to its logical end: When investors are all investing in the same asset, they're all just going to end up with a pretty lousy investment.
So it went with tech stocks in 1999 and condominiums in Florida in 2008, and so it will go with today's most popular stocks.
Are you prepared?
The only way to protect yourself from this inescapable truth is to know what today's most popular stocks are. That's why this next paragraph is the most important of them all:
According to data from Morningstar, emerging-markets stocks were by far the most popular stocks of 2009, with inflows of more than $18 billion.
Those inflows, in turn, have helped emerging-markets stocks rapidly increase in value. Even the plain-Jane Vanguard Emerging Markets Index, a megacap-focused collection of international names such as Itau Unibanco
Which brings us to the present
As a result of all of that love that's been showered on emerging markets, stocks in this market segment are generally expensive now. So if you take your cue today from what others are doing and blindly buy emerging markets, you may be dooming yourself to bad returns.
The flip side to that, given the prospects for a weakened dollar and the way that India, China, and Brazil weathered the recent global economic downturn, is that if you don't buy emerging-markets stocks today, you're likely to miss out on decades of economic growth.
The good news is that there's an out. Remember that people only fall back on social proof when they are given limited information. Our aim at Motley Fool Global Gains is to help investors buy emerging markets with far more thorough information. That includes insights like these:
- Rural China stocks are significantly cheaper than China stocks based in Beijing or Shanghai.
- Multinational companies that were seeing currency fluctuations drag on results are about to see currency fluctuations improve their results.
- Because of the price and the gray market, the iPhone isn't going to be as big of a deal in China as the media thinks it's going to be.
In other words, we want you to buy emerging-markets stocks today, but we don't want you to buy the same emerging-markets stocks everyone else is buying. To see what we do want you to buy, click here to join Global Gains as our free guest for 30 days (a $25 value).
This article was originally published Nov. 12, 2009. It has been updated.
Tim Hanson is co-advisor of Motley Fool Global Gains. He does not own shares of any company mentioned. Everybody likes the Fool's disclosure policy, so you should, too.