The herd mentality tends to ruin stock returns far more often than we suspect, but there is a way to find healthier long-term profits.
Ever jump on the bandwagon just before the wheels fly off?
Don't feel bad. Everyone has done that too. Maybe more times than they'd like to admit.
Here is the real kicker. You probably knew the investment was doomed in the long run, but as it went up and up and up, you felt like you were missing out. It turns out that this herd mentality tends to ruin returns far more often than we suspect.
Let me show you how to defend against the herd mentality to find healthier long-term profits.
When you see those high fliers run up 4%, 6%, even 12% in a day, do you think you missed the boat, or do you want to see if that run continues? Many investors fall victim to the high fliers far too late in the cycle.
We all know the party must end. It's inevitable. The problem is that the euphoria of a stock moving higher and higher causes you to believe that every dip is just another buying opportunity. As you buy more on the dip, you become severely over-weighted in a stock whose odds of success are between slim and none (and slim just left town).
Avoiding the high fliers is probably the best investment advice you will ever get. They will seduce you with their big moves up. But just like the siren song, it too often leads to a nasty crash in the end.
Turnaround stocks are another wily group. For all the successful turnarounds, there are dozens and dozens of stocks that never quite turned.
Even if it does go up in time, investors too often overlook a key element in the turnaround story… the element of time. Most turnarounds take a long time to unfold. So your money sits trapped in an unattractive investment, sometimes for several years. This waiting period completely erodes the ROI equation.
That's why I avoid turnarounds and broken stocks.
When I shop for growth, I look to the sweet spot. It's the place where I find growth companies too small to be on most radar screens. They are attacking an expanding market and are seeing estimates increase with every beat-and-raise quarter.
I am shopping in the middle of the pack. Meaning not glamour stocks with insane valuations, or taking a big chance on a turnaround. Rather these stocks give me the growth I am looking for at a reasonable price. I am not looking for the 50x and 60x forward earnings Internet B2B plays; the time for that has come and gone. I am looking for the next hot thing BEFORE it's hot.
The herd has yet to really catch on to these stocks… and the best thing about them is the herd even tells me when to sell!
Once my secret stocks see too much press for big gains and the bandwagon picks up, I jump off to avoid being on the wagon when the wheels come off.
Following the footsteps
A famous investor once said that he avoids the first 20% of a stock's move as it takes too long and carries far too much risk. He also sells out before the last 20% unfolds as he doesn't like going over the cliff when the masses sell out. The part he focused on was the middle 60% of the move because the odds of success were high and it took the shortest amount of time.
This mentality suits me as well. The key, once again, is to find that small cap stock that is poised for growth. Then make sure it has a solid earnings history, recent upward revisions to earnings estimates and is in a growth industry. The key indicator will be revenue growth that will allow margins to expand and earnings to flourish.
Once you have a nice gain, see if that stock gets some press that will be the signal to take some profits!
Brian Bolan is a growth stock strategist for Zacks.com.
The information supplied above by Zacks Investment Research Inc. contains opinions based on factual research which may or may not be accurate. Neither Zacks nor Intellisphere will assume any liability for losses from investment decisions based on this information.
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