Today, many “investment trend” websites are enticing online traders to join. Investors who follow the trend – also known as “momentum trading” – invest in stocks based on rising market prices rather than company fundamentals.
The strategy of following the investment trend performs best in a bull market. However, selling before the trend reverses is a skill that eludes most investors. When many investors buy the same stock, the market price can rise above the underlying value of the company. Eventually, as investors’ emotions stabilize, rationality may return, and prices fall into line with the fundamental value of the company (based on measures of revenues, earnings, etc.). Short-term momentum players who try to time market fluctuations seldom outperform buy-and-hold investors in the long term.
The trend can be a false friend
Herding behavior, whereby investors irrationally pile into a stock or sector, is behind most stock market bubbles. Two conditions for stock market bubbles are: new money inflows (which sustain the inflated price), and credit expansion (to generate the capital to invest). When credit conditions tighten, capital flows into the investment market slows and stocks start to decline.
When to bet against the masses
If a company’s fundamentals don’t support the stock price, it may be prudent to bet against the masses. Contrarians are often viewed as the mavericks of the markets. More often than not, their decision to go against the trend is based on thorough fundamental analysis.
If you base your investment decisions on sound fundamental security analysis, you may not always be a part of investment trends, but you will hopefully enjoy steadier and better long-term investment performance.
For more on the risks of following the trend, see my book review of Ben Bernanke’s book about the 2008 crash here.
Douglas Goldstein, CFP®, is the Director of Profile Investment Service, Ltd., which specializes in helping people who live in Israel with their US dollar assets and American investment and retirement accounts. He helps olim meet their financial goals through asset allocation, financial planning, and using money managers.
Published September 25, 2017.