From a psychological perspective, being a part of the herd feels comfortable. Going against the herd, in contrast, feels almost unbearably miserable.
Believe it or not, investment success is mostly about understanding this psychology, making a conscious choice to be in or out of step with the herd, and then acting accordingly over time.
Let me describe this in more detail. If the market is hitting new highs and your portfolio is going nowhere, it feels almost unbearably painful. If the market is hitting new highs and your portfolio is fully invested, it feels great to be “participating” in the run-up.
This is called herd psychology for good reason. When running with the herd, animals are least likely to become a predator’s meal. When running against or away from the herd, you’re quite likely to become lunch. Our general psychology reflects this herd bias because it worked oh-so-well during human evolution. Being away from the herd is painful.
This carries implications for investing. If you prefer running with the herd, or know yourself well enough to acknowledge you’ll feel miserable standing apart from the herd, then invest in an index fund. The benefit is you won’t feel the psychological pain of being out of step and thus make big investing mistakes at just the wrong time. The downside is you’ll generate mediocre results and thus have to save more money over time.
They key is objectively understanding your temperament, and then making a choice that you can actually–not hypothetically–stick with. You must know yourself, first.
If (and that’s a BIG if) you have the temperament or will-power to run apart from the herd, the benefit is you can achieve above average results, and thus have a bigger retirement or reach your retirement goals with less required savings over the years. But, you must be able to tolerate the psychological pain of being out of step. This is no trivial matter.
Most people say they would prefer to do better than the herd, but very few actually have the stomach to do so. They believe they can stick relatively close to the herd and generate better results, but they simply can’t. They say they can tolerate being out of step, but when their portfolio is going nowhere and the market is moving up, they get cold feet and decide to jump back into the herd.
This is why they do worse than both the herd follower and the out-of-stepper who can stay the course: flipping from out-of-stepper to herd follower and back again–at the time of maximum psychological pain–over and over again, generates terrible results (Dalbar publishes results each year supporting my position).
The important point isn’t which method works best by itself, but which method you can stick to from a psychological standpoint.
Beating the herd is not impossible, but it requires a willingness and ability to go against the herd through the psychological pain of being out of step. Fewer can do it than are willing to admit it to themselves, but that’s also why it works.
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.