The myth
Behavioral biases can influence how you make decisions, from choosing what to eat and wear to dealing with money and investing.
These biases include herd instinct, or the urge to do what most people are doing. Instead of doing their own analysis, some investors tend to follow the crowd thinking that so many people can’t be wrong, and the majority must be right.
However, when emotion takes over and people fail to think critically, herd behavior can lead to ill-informed investing moves.
To avoid the pitfalls of herd instinct, some people choose not to follow the crowd or even intentionally go against the majority. The latter is an approach called contrarian investing.
The reality
Contrarian investors do the opposite of what most people are doing. When many are panic selling, they buy the affected assets to take advantage of bargain prices. They sell when others are buying to potentially make a profit.
Contrarians believe most investors tend to overreact to news and can become overly optimistic or pessimistic. They also feel that others take shortcuts by making copycat moves instead of checking the facts themselves.
When optimism is high, prices may rise beyond reasonable levels and eventually drop. When pessimism takes over, prices of assets may fall below their “real” value, creating an opportunity to possibly buy low and sell high later on.
Contrarian thinking is all about trying to get ahead of the curve. You’ll exit an investment before the decline and buy before it climbs.
There’s a risk, however, that you’d be too early with your contrarian moves. Even if you think the crowd is wrong, you’ll never know how long it would take before your decision pays off.
A losing investment can continue to drop after you buy. You might miss out on higher earnings if a booming investment keeps climbing after you sell.
For this approach to work, you need to have a good sense of how investments might perform. You should also be able to tell when the prevailing sentiment has become irrational and is about to shift.
Note that you’re not required to choose between following or going against the herd. Contrarian investing is simply 1 option for those who aim to capitalize on market trends and can handle the risks.
Regardless of what other investors are doing, you should choose what’s best for your situation by doing your own research and considering your needs and goals.
Verdict: It depends.
Questioning the herd can keep you from following others blindly. When you remember that the crowd isn’t always right, you can be more thoughtful about your investing decisions.
Being thoughtful also means you don’t have to be a contrarian for the sake of it. You can instead review the facts first and understand how trends may (or may not) affect you before making a move.
