How You Can Beat the Investing Herd

This article is part of ourBetter Investorseries, in which The Motley Fool goes back to basics to help you improve your returns and be more successful with your investing.

In recent years, small investors have increasingly felt as if Wall Street tycoons have stacked the cards against them. But for good or ill, investing requires emotional discipline first and foremost, and without that, you're doomed to make the same mistakes that countless others have made for decades.

One of the first lessons that beginning investors hear about is not to follow the herd. The reason for that is simple: There's lots of evidence that shows that the herd collectively makes some really dumb moves, so you're better off going against the grain. Yet time and time again, the masses of ordinary investors ignore that advice -- and then complain that they've been hoodwinked yet again.

The psychology of bear markets
You can see what may be the best example of this phenomenon in mutual fund behavior. Every week, the Investment Company Institute publishes figures on various categories of mutual funds and how much money shareholders have put in or taken out of each category. By looking at those figures, you can get a sense of what average investors are doing at any given time.

Just looking at the past few months, you can see a massive move out of the stock market from fund investors. Since June, stock mutual funds have seen outflows of nearly $100 billion, almost all of which came from U.S.-oriented funds. Meanwhile, bond mutual funds have generally continued to see strong inflows.

If you followed the herd, your gut instinct would be to join the crowd and sell your stocks before they fell any further. Yet history has shown that to be a mistake. During the financial crisis in late 2008 and early 2009, stock mutual funds saw the same massive withdrawals as investors sought the security of cash. Even after the bottom was hit in March, fund investors were slow to gain confidence in the move. In fact, most of the money that investors took out of stock funds during that period never went back in -- resulting in millions of investors completely missing the market recovery that led the S&P 500 to double from its March 2009 lows.

How to beat the crowd
If you want to win at investing, the first thing you have to master is ignoring the crowd and having confidence in your own judgment. It's easy to get caught up in groupthink, but if you find yourself agreeing too much with consensus opinion, that's when you have to be most critical of your own thinking to make sure you're not making what in retrospect may prove to be an obvious mistake. Ideally, though, you'll buck prevailing thinking and find investments that most people haven't discovered -- yet.

One obvious sign that fear of a stock is irrational is a low earnings multiple despite healthy expected growth. You'll find this with many companies in troubled industries, especially bank stocks, that you might not want to touch right now. But a few stocks tied to energy and other natural resources, including SeaDrill (NYS: SDRL) , ArcelorMittal (NYS: MT) , and Marathon Petroleum (NYS: MPC) , also fit that bill. It's true that they're potentially vulnerable to a cyclical downturn in the economy, but their current prices already reflect some expectation of that possibility -- and contrary to popular opinion, downturns do eventually end. An ETF like the Energy Select SPDR (NYS: XLE) would give you exposure to many companies in the energy space, while Vanguard Materials (NYS: VAW) covers many other natural resources.

The same holds true for industries facing considerable uncertainty. For instance, WellPoint (NYS: WLP) and Aetna (NYS: AET) have taken the double hit of being in the insurance industry as well as having exposure to the ever-changing health-care reform situation. But with such stocks experiencing single-digit P/Es, the crowd seems convinced that the entire industry is doomed to much lower profits -- ignoring the very real possibility that a greater reliance on private health insurance could actually boost those profits going forward. The Health Care Select SPDR includes these two insurers along with other stocks in the industry.

Be yourself
Nothing's harder than bucking the trend, especially when, at first, the herd seems to be right and you're on the losing end of your trades. But to become a better investor, you have to have the confidence, conviction, and discipline to stick with your views until hard evidence refutes them. If you can do that, you'll have accomplished one of the hardest aspects of expert investing.

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Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitterhere.

At the time thisarticle was published Fool contributor Dan Caplinger is amazed just how far he's come since he first started investing 25 years ago. He doesn't own shares of the companies mentioned in this article. Motley Fool newsletter services have recommended buying shares of WellPoint. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy gets everything right.

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