Following the Stock Market Herd Often Wrong Decision

Momentum in the stock market is a powerful force, however it is often reflective of emotions more than logic.

The evidence for this is played out every time the market experiences rapid growth or decline.

Investors jump on the movement and provide it with energy to keep it moving in the same direction in the face of logic, which is often contrary to what is actually happening.

During the dot.com boom of the late 1990s, investors, seasoned professionals and amateurs alike, piled cash into the market way beyond any measure of rational investing logic.

Taking Stock Profits

When investors who had gotten in early should have taken profits and rebalanced their portfolios out of technology stocks did not, they lost all their profits and much more when the bubble burst.

Likewise, during market downturns, investors frighten easily and dump stocks for “safer” investments such as bonds and cash.

More stocks are held in mutual funds than by individuals. When fund investors sell their shares, the fund manager must come up with the cash.

If a significantly more shares are being sold than new shares are being bought, fund managers have a net outflow of cash.

Cash Flow

To cover the negative cash flow, fund manager usually must sell shares of stock they hold, sometimes when they would rather hold the stock or buy more shares at depressed prices.

This selling to redeem mutual fund shares simply drives stock prices down further, which frightens even more investors to redeem even more mutual fund shares and the cycle continues.

The cycle of market momentum is broken when net dollars begin flowing back into the market.

If investors can make intelligent trading decisions during downturns and rebalance during booms, they will come through these market cycles in much better financial shape than if they follow the market herd.

The market herd (momentum) may be powerful, but it is often wrong.