When it comes to investing our money, human nature likes to play tricks on us. When the stock market is reaching new peaks, we can't wait to jump in. When it stumbles and falls, we stop investing - or worse, we start selling. Despite the lessons of the past, that insistent inner voice keeps urging us to follow the crowd.
As a result, the typical investor tends to buy high and sell low - exactly the opposite strategy needed for profitable investing.
Decades of experience have clearly demonstrated that when a rising market starts to look like a win-win situation, it's at its riskiest. When the market is mucking around in a slump, the gloom and doom tends to grow, keeping us from taking advantage of a buy-low situation.
The stock market boom of the late 1990s provides us with a classroom example of how costly our tendency to follow the herd can be. In early 2000, stock values soared to their highest levels. Investors were falling over themselves to get in on the action.
Most of that new money was going into technology funds. By March 2000, investors had poured tens of billions of dollars into technology funds.
That was the worst possible time to invest. By October 2002, the S&P 500 index had fallen nearly 50 percent. Even worse, the NASDAQ had lost more than three-quarters of its value.
At that point, with the market at its lowest in the cycle, investors started taking more money out of funds than they were putting in. Then, the markets began their recovery, reaching a new peak in October 2007.
Moral of the story
The moral of this story is quite clear. Listening to that inner voice telling us to follow the crowd may be exactly the wrong thing to do when it comes to investing our money.
When investors are pouring money into the market, causing it to rise, we expect it to continue rising. When the market falls, we expect it to continue falling.
That's human nature at work; it's telling us that whatever is happening now will continue to happen. Of course, as we all should know by now, it doesn't work that way.
Avoiding the abyss
How can we keep ourselves from falling into that buy-high, sell-low financial abyss?
One of the strategies favored by many financial advisers is called dollar-cost averaging. That technique calls for establishing a fixed dollar amount to invest at regular intervals (e.g., monthly) and sticking with that pattern, regardless of whether the market is going up or down.
With dollar-cost averaging, when the market is rising, your money will buy fewer shares, and when it's falling, your money will buy more shares.
Since the market has a positive mean rate of return, proponents of this technique suggest that by buying your shares at the average price over a period of time, you will benefit from the market's average return.
Be advised, though, that not everyone agrees with dollar-cost averaging as a profitable investing technique. Some say that using this method guarantees a return less than the market's average. Before you set this technique for your investments, you should do your own research.
Many professionals and seasoned investors recommend the buy-and-hold philosophy. This calls for buying only stocks with solid fundamentals or mutual funds with low expenses and good diversification, then sticking with them throughout both good and bad times.
In other words, ignore the crowd and avoid reacting to the emotion of the moment. This can be tough to do when the market is in a dive, but remember, following the herd is almost always the wrong thing to do.
Arguably, the best advice of all when it comes to your personal investment philosophy is to stay focused on the long term. In our world today, there will always be news of the sort that invites a reaction from investors.
As a long-term investor, your goal is to stay focused and avoid short-term distractions.
When it comes to investing your money, separating yourself from the herd will almost always work to your advantage.
Information in this article is provided for educational and reference purposes only. It is not intended to provide specific advice or individual recommendations. Consult an accountant or tax adviser for advice regarding your particular situation.
Mr. Lynott is a former management consultant and corporate executive who writes about business and financial topics for various consumer and trade publications. His latest book, Money: How to Make the Most of What You've Got, is available through most bookstores. Reach him at email@example.com or through his Web site: http://www.blynott.com/