The Common Sense Investor

The easiest way to get duped in the stock market is by chasing after fads and buying what everyone else wants.

It is an economic fact that anything that is in high demand gets sold at a premium. This applies just as much to stocks as it does to televisions, cars and gasoline. You want the biggest flat screen TV? Expect to pay a premium. You want gasoline on the same day that everyone else wants gasoline (e.g. during a hurricane)? Expect to pay a premium. You want that glorious Google stock that everyone else wants? Expect to pay a premium. You want the 2007 model of the Ford Mustang instead of the 2006 Hyundai Accent? Expect to pay a premium.

“Ok”, you say, “but there’s nothing wrong with paying a premium if I get something worthwhile out of the deal.” And that’s true. But the real question is whether you are getting real value or not.

More often than not in today’s economy, if everyone wants something, one of two things applies. In the first case, you are being psychologically duped by the marketers into thinking that the product is better (quality) than it really is (i.e. that there is a huge difference between a 2006 and 2007 model of car, when they really just want to get rid of their 2006 inventory). In the second case, you are being duped into thinking that the product is more valuable than it really is (i.e. that is can return 20% when it really can only return 4%).

When it comes to investing, as a principle, you really should avoid chasing fads. While you may profit in the short term from momentum runs, you become much more prone to the effects of exploding bubbles. In the 1999-2001 tech bubble crash, everyone who had been riding the wave of the tech fad got crushed. Why? Because while they were buying stock, they were buying what everyone else wanted, so they were paying a premium. Buying at a high premium (high P/E ratio) provides very little room for upward movement, and a whole lot of room for downward movement. When no one wanted tech stocks anymore, all those profits sunk with the cresting wave.

The wave analogy is actually a good one. If you are there at the beginning of a wave then you can benefit as the wave grows to its peak. But if you just jump onto the wave as it is reaching its highest point, you might get a little higher, but pretty soon you’ll crash back down to sea level.

Chasing fads in investing is like jumping on the wave at the peak just in time to crash and lose money. The best investors are able to get on the wave just as it is beginning to emerge, ride it for a while, and then get off before it crashes.

One of my favorite investing analogies comes from one of my favorite mutual fund managers, Ronald Muhlenkamp, who says that investing is like farming. If you plant your crops in April or May, then you’ll have a good harvest in October. But, if you wait until September or October to plant your crops, you’ll have a disastrous harvest. The problem is that the majority of people don’t start to plant their crops until they see the best investors gathering their harvest.

The following of crowds and chasing of fads isn’t just bad in the world of stocks. It is also bad in the world of real estate investing. Amateur real estate investors are prone to speculate on properties when prices are rising, hoping to jump on the wave for the ride. But the key to real estate investing is to follow the real estate market cycle by buying low (planting in April) and selling high (harvesting in October).

Instead of chasing fads, put in the hard work to discover good companies selling at cheap prices. By doing this, you’ll inevitably catch many waves on their way up. Just make sure that you are prepared to sell when the company becomes overvalued and the wave begins to crest.