The science of behavioral economics delves into the ways our brains trick us into doing stupid, irrational things with our money. Among the many odd patterns it's observed: the bandwagon effect, which suggests that we often do or think things solely because many other people do so, too. Unfortunately, by sticking with the herd -- especially in the stock market -- we often set ourselves up to fail.
Bubbles and trouble
Think back to the Internet stock bubble of the late '90s. Yahoo! (NASDAQ:YHOO) shares traded at a split-adjusted $24 at the end of November 1998, then more than doubled in just a year to $53 by the end of November 1999. Just one month later, they closed at $108. Do you think that the company had somehow shown itself to be twice as valuable from one year to the next, and then from one month to the next?
Nope. People saw the price rise, and the faster it rose, the more they irrationally wanted to jump onto the bandwagon. By the way, I don't exclude myself here -- I was just as stupid and greedy as many other investors, which cost me the better part of what could have been mammoth gains.
Mary, Mary, quite contrary
Warren Buffett has offered this sage advice: "Be greedy when others are fearful and fearful when others are greedy." In other words, he's urging us not to hop on the bandwagon.
Indeed, the entire strategy of value investing is based on not following the crowd. Value investors seek companies that are trading for considerably less than they're worth. They owe their bargain prices to a general lack of respect from the market. The bandwagon is elsewhere.
If you'd like to look for value-laden stocks, a Motley Fool CAPS screen might be a great place to start. Here are just a few of the companies we unearthed in a search for solid returns on equity (ROE), little debt, and relatively low P/E ratios:
|
Company |
CAPS stars (out of 5) |
ROE |
Long-Term Debt-to-Equity |
P/E |
|---|---|---|---|---|
|
United Technologies (NYSE:UTX) |
**** |
22% |
0.47 |
17 |
|
Precision Castparts (NYSE:PCP) |
***** |
17% |
0.04 |
17 |
|
Jacobs Engineering (NYSE:JEC) |
***** |
15% |
0 |
13 |
|
Ensco (NYSE:ESV) |
***** |
17% |
0.05 |
7 |
|
Honeywell (NYSE:HON) |
**** |
23% |
0.66 |
14 |
|
optionsXpress Holdings (NASDAQ:OXPS) |
***** |
22% |
0.0 |
15 |
Data: Motley Fool CAPS.
Rather than following the crowd, think for yourself. If the market drops sharply, and everyone you know is saying, "It's time to get out of stocks!" remember that the crowd is often wrong. Such a prolonged period of panic would actually be a good time to buy. In the long run, stocks have risen -- especially for investors who've strayed from the bandwagon to seek out the best and deepest stock bargains.
