To make profits, break out of the herd

The instinct to follow the herd is hard-wired into our brains, but it doesn't make for profitable investing. Striking out on your own may be daunting, but, as Tom Bulford explains, it can lead to much higher gains.

A fascinating letter in The Times has drawn my attention to an article in the neuroscience journal, Neuron. The piece was entitled 'Reinforcement Learning Signal Predicts Social Conformity'. What it revealed is relevant to you and all investors.

The gist of it is that our brains are geared to mimic our peers. When we fall in line with the consensus our brains release a chemical called dopamine. That makes us feel good. On the other hand, going against the crowd triggers a neuronal response that makes us feel uncomfortable. And the more uncomfortable we feel, the more likely we are to make 'subsequent conforming behavioral adjustments'. In other words, we're likely to change our mind and go along with crowd after all.

I think the medical researchers who have demonstrated this could have saved themselves some time by studying the financial world. When it comes to investment, herd behaviour is well established. My favourite analogy compares investors to a herd of zebra roaming the African veldt. Those 'safety first' zebras in the middle of the herd don't get to eat much grass. The risk-taking zebras on the outside of the pack have got there first. On the other hand, the ones in the middle are much less likely to be attacked by a hunting lion they have comfort and safety in numbers. Such is risk and reward in the animal kingdom.

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It's hard to go against the crowd

The point is, it is very hard to go against the crowd. We know that from a young age. There is nothing worse than being excluded from the school in-crowd. The desire to look like everyone else explains why teenagers wear jeans that come half way up their thighs. How can this be unattractive if every other teenager seems to think it looks cool?

So by the time we get to the age of managing our finances we are all too ready to conform. Down in the City this is well known. Marketing of financial products is done on the basis of giving the customer what they think they want and not what is good for them. If everybody is excited about technology then technology funds are launched left, right and centre. This is how bubbles form.

Ultimate disappointment is inevitable and it is all the harder to bear because, for a time, the crowd seems to be right. All the money that is subscribed to these new funds pushes up share prices. Companies in these sectors find it easy to raise cash. And with a wad of investors' notes in their pockets, company executives find it easy to paint a rosy picture of the future.

But soon the wall is hit. Valuations get too high. Companies do not deliver on all those promises they had made to investors. Cash comes out of these funds just as fast as it went in. Fund managers are forced to sell, but nobody wants to buy. Investors lose money and retire to lick their wounds.

How the contrarian looks beyond the 'news'

This is all because they followed the herd. It is all because, when they decided to invest their money in the same thing as everybody else, some part of their brain sent out a little signal that made them feel happy. And it's incredible how often this lesson has been learnt only to be forgotten when the next stampede gathers pace

Of course, it is incredibly hard to develop a contrarian spirit and bet against the crowd even though we know that all the great investors have it in abundance. Shares are getting cheaper and cheaper, especially amongst the friendless small companies. It's not comfortable in small caps right now we're like the zebras on the edge of the herd.

Yesterday I cheered when HSBC launched the biggest rights issue in history to shore up its balance sheets. Of course, the bank's shareholders weren't cheering with me. They didn't like it one little bit the rights issue dilutes their share price.

But in an indirect way, HSBC's woes could be good for small cap investors. The money raised by the rights issue could ultimately get the bank lending again. Some of it will end up financing small companies through the recession.

Sometimes what seems like bad news is good news the only problem is that your brain does not report it that way!

It may be tough in the market right now. But in the long term, investing in the stock market beats any other asset class. And as we saw last week, over time, small caps have beaten large caps by an average 2.3% each year.

They may be unloved right now, but this is a great time to be picking up carefully chosen small caps in the right sectors they should lead the charge higher when the markets turn.

This article is taken from Tom Bulford's free daily email, Penny Sleuth.

Tom worked as a fund manager in the City of London and in Hong Kong for over 20 years. As a director with Schroder Investment Management International he was responsible for £2 billion of foreign clients' money, and launched what became Argentina's largest mutual fund.

Now working from his home in Oxfordshire, Tom Bulford helps private investors with his premium tipping newsletter, Red Hot Biotech Alert.

Follow Tom on Google+.