Corralling the Herd

As regular Tradecraft readers know, few things are as financially dangerous as following the uninformed mass of investors to which we often refer to as "the herd." While nobody makes money all the time, the herd has an undeniable knack for losing it again and again, in almost every conceivable fashion. Following the herd's movements, therefore, is a worthwhile endeavor. The more I study what the herd is doing, the better I'm able to avoid following in its footsteps.

When it comes to investing, what matters isn't what we say, but what we do. So it's not too surprising that, when opining on the market, the herd tends to talk in generalities or about things that have no impact on the bottom line. When you're uninformed and just part of the pack, it's a lot more convenient to talk about the economy, Bush, jobs or some other piece of non-tradable minutia than actually commenting on what's happening in the market itself. When you hear someone talking loud (but saying nothing), chances are they're part of the herd.

It's why I avoid watching business TV, reading stock market publications and being influenced by anything other than the market itself. A trader should watch the price action, not the news, and by the time XYZ starts getting mentioned on TV, in magazines or on the message boards, one can expect that the herd is beginning to take an interest in buying it. For me, that tends to be a good time to consider cutting back positions on XYZ, and for new money, simply avoiding it altogether.

Interestingly enough, the herd itself is often exactly wrong about where the herd actually happens to be. For example, conventional wisdom dictates that it is buying interest that moves a stock higher. Strongly performing stocks, they say, should be avoided, because it's the herd's buying power that has already pumped the price. It's a favorite fallacy of — you guessed it — the herd.

But as we pointed out last summer, it's just as likely to be the absence of sellers as the presence of buyers that prompts a market to move higher. In fact, oftentimes stocks will have their biggest moves well before the herd begins piling in. For instance, while precious metal stocks were star performers in 2001 and 2002, it wasn't until the past 12 months that mainstream investors began adding shares to their portfolios. The best example, of course, is the 1990s bull market, when stocks rose for four years straight before most people finally bought — in the first quarter of 2000.

That's the thing about the herd: despite often losing money, it is strangely hesitant to take a chance. Although this is a business of speculation, the herd prefers to bet on the "sure things" that in hindsight usually turn out to be anything but. Again, the tech bubble provides an excellent example: for most of the 1990s, the herd deemed Microsoft (MSFT), Cisco (CSCO) and other Nasdaq darlings to be overvalued and far too risky. Yet at the height of the bubble, once the Internet's scope had finally begun to be realized, not investing in technology seemed, well, sacrilege. Of course, by then, the real move had already been made.

And when the herd does put money on the line, it tends, ironically, to be both the least educated and the cockiest group of investors you'll ever find. While experienced traders approach the market with a healthy dose of skepticism, prudence and care, it's the herd that is more than ready to bet the ranch with a "can't lose" investment. And it's that overconfidence that leads it to stay with (and sometimes double down on) losing trades in weak stocks. Because the trade concept seems so strong, the herd becomes blind to the fact that the trend has already changed. The herd's technique is flawed, its discipline all but nonexistent.

But while the herd is to be avoided, it shouldn't always be fought altogether. As I often point out, investors can't bet on everything — they must pick their top choices. The herd's picks are never my top choices. But just because I'm not buying a stock doesn't mean I'm shorting it. Sometimes, I'm simply not buying.

Where do I look for the herd? I'll check out the message boards and mutual fund flows. I'll glance at a few magazine covers or see what the investment clubs are doing. I'll talk with my barber and listen closely at cocktail parties. The herd is somewhat hard to describe, but it's a little like pornography: you know it when you see it.

Some of the best trades are the ones you don't make. Because while nobody knows the future, some investors are doomed from the start. The herd never comes out on top. Fighting it isn't always the answer, but following the herd never is.

Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC.