Avoid the Herd Mentality

When people first start investing, they often believe they'll make their investment decisions based purely on facts and research, but they end up letting their emotions run the show. This can lead to investments that don't fit into the investor's plans and portfolios. For example, it's very tempting to follow the herd and buy what everyone else is buying. But when a bubble bursts, like the tech bubble did at the end of the 1990s, investors learn the hard way not to invest just because everyone else is doing it.

You can't outperform the market if you buy the market. Bernard Baruch, an economic advisor to Woodrow Wilson and Franklin Roosevelt, was a firm believer in this principal of market investing, saying repeatedly, “Never follow the crowd.” If you buy with the crowd, you will achieve the same results as everyone else, good or bad.
Following the crowd is a major part of behavioral finance, a relatively new analysis approach that many investment professionals now use as part of their overall strategies. Traditional market analysis is founded on the idea that investors behave rationally and make their decisions only after carefully considering all available information. Behavioral finance adds a more human component by combining basic psychology with investing.

It turns out that many individual investors often act irrationally when it comes to making their buy and sell decisions — for example, they might trade based on the popularity of a stock rather than its value or growth potential. This emotional trading usually leads to losses, yet these investors continue to make the same types of investment decisions. In the relatively new field of behavioral finance, these poor decision-making strategies are examined and linked to market irregularities like crashes and bubbles.

Here's how behavioral finance tends to work. People jump to buy a stock because it's hot. That drives up the price, and more investors snap up shares. It makes no difference that the company has an unproven track record or is loaded with debt — all that matters in the heat of the trading moment is the excitement of owning this very popular stock. The number of investors who jump on that bandwagon alters the patterns and directions of the stock market — and not necessarily for the better.

Corporate websites are an invaluable source of information in helping you make your investment decisions. In a study of individual investors, 74 percent said they visit a company's website before investing in a company and 53.6 percent visit often before making a final decision to invest.
The irony is that while many investors have no problem plowing their hard-earned money into portfolios stuffed with complicated creatures like biotech or nanotechnology stocks, these very same investors pause when given the opportunity to invest in a classic alternative investment like a hedge fund or a real estate trust.