10 Tips to Avoid Following the Herd in the Wrong Direction
Psychologists have discovered in situations when the “Do Not Walk” sign is illuminated, people are more likely to cross the road if the person ahead of them starts to walk, often without looking to see if it’s safe. Soon after hearing about this study I was in Midtown Manhattan, late for a meeting, jogging across streets whenever I saw an opening in traffic. Proving this study as accurate, I would hear taxis honking behind me because others had followed my lead, but they didn’t have as much of a gap in traffic. Unfortunately, too many investors get hit by a car while trying to cross this figurative street.
Appreciate human emotions cause markets to always overreact on the upside and downside – which nimble investors can exploit
Let’s not forget that all great stock calls are the result of an out-of-consensus idea proving correct over time. So how can an analyst have a great stock call by following consensus? They can’t. If an analyst is following the same mindset as most of the market, it will be virtually impossible to generate alpha. For this reason, it’s critical not to follow the herd.
Of the four primary mind traps I discuss in another post, “Following the Herd” is probably the most pervasive and dangerous of them all. Therefore, in this post, I provide 10 tips on methods to help avoid these missteps:
- Before making a recommendation, determine where your psyche is on the “greed vs. fear” spectrum compared with consensus. If you (as well as consensus and the media) pay little or no attention to the downside risk, you’re too far in the “greed” camp and if you are racing for the doors to sell because of media reports (rather than fundamental research) you’re probably too far in the “fear” camp.
- When a stock appears to have dropped too much due to new concerns, avoid waiting for the market to get “greater clarity” about the risk, because it’ll be too late to benefit from the opportunity. The lack of clarity creates an opportunity to exploit. This is among the 3 biggest mistakes I see in professional investing, specifically when a PM or analyst is asked if they would recommend buying a stock that has a near-term risk to which they respond, “I’m waiting for better visibility” on the issue (you’ll see this all the time on CNBC). That’s what clients pay them hefty fees to do…get visibility before the general market!
- If a substantial upward move in a stock was missed, be hesitant to chase it such as jumping on the bandwagon. Making the same trade as everyone else begs the question, “Who’s going to take the other side of the trade when you want to get out?”
- Increase the urge to sell when everyone loves a sector or stock, and buy when no one wants to own it. A few telltale signs to sell (or avoid buying) a stock are when:
- Valuation is reaching or exceeding peak levels
- All or almost all sell-side analysts have buys on a stock
- The general view in sell-side reports and the financial press is, “It’s different this time,” or, “Nothing can go wrong.”
- The stock no longer reacts positively to good news
- Conversely, observe when bad news no longer makes a stock(s) go down because it’s usually a sign the “herd’s” psychology is shifting. I recall when covering transport stocks, they would often drop on days when oil prices suddenly jumped, but there were times when this trend would suddenly stop, which was usually a sign the stocks were nearing a psychological floor that longer-term investors were willing to support.
- Use a short squeeze as a short-term selling opportunity, due to the panic buying (these tend to be short lived, and as such, shouldn’t be used as the rationale for setting a price target.)
- If long a stock, avoid panicking when other investors who are short the stock attempt to over-blow the impact of negative news flow.
- Observe when a stock continually overreacts in one direction to news flow during a relatively short period of time, because it could be a sign of irrational buying or selling. There was a time when Apple’s stock rallied on any type of media report, even those that had no implication for long-term earnings growth.
- Making impulsive stock calls usually leads to problems. I recommend “sleeping on it” for stock calls stimulated by a sudden event. This problem often rears its ugly head when a company reports disappointing results or lackluster forward guidance after the close and a number of sell-side analysts lower their ratings that night. The next morning the stock opens down 10%-15%, often offering a great entry point. Unless there is fraud or no hope of the company making improvements, there’s little value in telling someone to sell a stock that’s going to be down 10%-15% on the first trade of the day.
- Buying turnaround stories is difficult (they rarely turn around). If you’re brave enough to use this strategy, watch for investors to capitulate before building a position. With deep value investing, the stocks are usually “cheap” because of a problem. If a good portion of the market is assuming these problems will get resolved (i.e. out-year consensus estimates show a big improvement), it’s probably not a truly deep value candidate. The best candidates are where the analyst’s work show the consensus is incorrectly forecasting the company’s prospects will not improve.
The next time you’re about to make a change to one of your stock recommendations, ask yourself if you’re likely walking along the same path as a mass of other investors. Remember a herd can’t generate alpha. Instead, follow the philosophy of Robert Frost in his poem “The Road Not Taken.”
Let me know if this Best Practice Bulletin™ helps and how I can improve upon this best practice. If you’re interested in exploring this topic further, AnalystSolutions provides equity research training with a specialized workshop to help Master the Stock Call Techniques of Highly Experienced Analysts
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©AnalystSolutions LLP All rights reserved. James J. Valentine, CFA is author of Best Practices for Equity Research Analysts, founder of AnalystSolutions and was a top-ranked equity research analyst for ten consecutive years