Why You Should Avoid Crowded Trades and Investor Stampedes

You Should Always Avoid the Crowded Trade

Business Man Riding Horse in Stampede
Horse Stampede with Man. John Lund

As investors, we generally want the same things: more profits, bigger profits, and easier profits. Basically, most people want to invest their money into a stock which increases significantly in value, and typically they do not really care about the actual underlying company.

This makes sense, of course, because a company operates from day-to-day to advance their own issues, prospects, and strategy, with or without the investors.

All the decisions, as well as the successes and failures, should be left to the management team which is running the company. It is the job of the executives to produce value in the shares by having the results which increase the price of the shares.

If you can turn your $1,000 into $2,000 without a lot of involvement, why would you care (or even why should you care) about the moment-to-moment interactions and maneuvers of the underlying company? The prize is not about the company being successful for the company's sake, as much as the value of the original investment increasing in "worth," and showing a profit for shareholders.

Actually, it is funny—if your chosen stock does increase in value, then you might believe you are a great investor. If that same equity had slipped in value, you might feel like you are not "doing it right." However, the moves of the share price may or may not have anything to do with whether or not you are a good investor.

Unfortunately, this results in investors making their trading decisions with very shallow or wholly inadequate due diligence. People are busy, and many of them do not understand all the intricacies of investing in companies on the stock market, and it takes an excessive amount of time to do it properly.

 

Therefore, most people take the exact path which you would expect—they will invest their money based on a single concept or two. For example, they may think that a specific industry is going to expand, or government regulations are going to change the way that specific companies operate, and so these must be good investments.  

Unfortunately, this is not an effective approach, and typically backfires. It leads investors into a trap, where thousands of others may have the same simplified logic, thus resulting in wildly-overvalued investments.

When you have a major portion of the population doing the exact same thing, the path is typically crowded, ineffective, and disappointing. To extend this concept one step further, you will see that this "low-work," "low-experience" individual will buy shares of an investment simply when they believe the most shallow, basic analysis of the industry, or idea.  

The risk is that the logic feels like it makes sense, and should result in the underlying stock increasing in value. The reality diverges pretty significantly, however, and the end result is ALWAYS going to be that the particular investments come back down to earth. The masses lose, so look around—if you are a part of a bigger mob, you will want to think twice about your purchase.

Many investors are quiet most of the time, but when a potential opportunity starts showing up on the news (such as legalization of marijuana, digital currencies, or Dot Com stocks), these people will come out of hiding. They believe their shares can perform well, perhaps even making something significant out of a small investment of a few hundred dollars.

Who wouldn't want a part of that excitement and potential reward? Hey, I get it, but anytime I personally have made a winning trade, it was based on exhaustive and significant due diligence and analysis. I wish it were different, but investing well works just like everything else— it takes an extensive amount of work. This is, in fact, true of marriages, weight loss, or basically to be successful at anything.

Unfortunately, since many of these shallow decisions are based on thin information, you will typically see numerous groups of investors all making the exact same move.

Many investors think that they are so clever, or doing strong due diligence, because they believe that one specific event will result in the specific companies involved seeing their share prices skyrocket.

Usually, by the time significant amounts of investors are getting involved with one single subjective thought or concept, it is very widely known. Many individuals never consider the fact that as they heard about the idea, so did tens of thousands of other people. 

The final result of all of this is that the underlying stocks are typically driven well above their fair valuation, and the prices leave little room for further upside. This is certainly true by the time that most people have heard about an individual concept (for example, when a person realizes that they should be invested in a marijuana company before the legalization of recreational marijuana).  

The individual investor is typically so far behind the game. All they end up doing is throwing their money into overvalued shares, right before those investments collapse in price.

We are seeing this right now with companies related either directly or indirectly to cannabis, however, the same concept of investor stampedes play out time and time again. Every instance ends up the exact same way.

The trade gets saturated. The investments are stupidly overpriced. Reality brings them back down to earth.

Whether you talking about the tulip bulb mania in Holland, or the gold rush in California, or Bitcoin mania, or the Dot Com bubble, or the current marijuana stock stampede, individuals who get involved when the concept is in the news almost always lose. Even when the mob went crazy for the 1,800 American automobile manufacturers at the at the turn-of-the-century, the vast majority of people who get involved can kiss their money goodbye.

There is no further upside to the investments by the time the biggest portion of society hears about the prospects. While it will seem counterintuitive, when you hear about some great potentially profitable idea, it is typically at the point where the underlying investments are about to decrease significantly in value

Any popular concept is a crowded game, which will become even more crowded if and when the underlying investments show any early successes. For example, if marijuana penny stocks increase in price (despite the fact that they may be worth zero), you will only see the mania become more pronounced, and spread even further. Then, that same strategy will suddenly become like a ghost town. 

When the shares of wildly overvalued, tiny penny stocks stop rising... and when the trading activity in the underlying companies starts to decrease... the share prices start moving towards fair value. This, unfortunately, is typically around zero dollars, and zero cents.

Thus, the interesting and cruel thing about investor manias is that by the time you hear about them, you're almost certainly about to lose. All the profits get collected early in the game, before anyone knows about the underlying opportunity

In fact, it is actually the increase in exposure and interest in an individual concept which is what really starts driving those shares higher. Then, the higher they go, the greater the upcoming collapse.

In other words, the actual act of the investment in stocks which are increasing in price generally suggests and implies that you may want to think about taking your profits. At the same time, any time an investment increases during a mania or a stampede, that is just a reflection of how much the investors will lose when that investment comes back down to fair value.