Why Following The Herd is Making You a Bad Investor

One of the arguments in favor of picking individual stocks is that you can find interesting opportunities that are undervalued and invest in them.

But what if your choices are being influenced by outside factors that have nothing to do with the stock itself? 

Source: Flickr / goingslo.

The Influence of Analysts
Stocks are covered by analysts, who write reports based on public filings and offer buy and sell recommendations. Generally speaking, the bigger the company, the greater the coverage, so large cap stocks enjoy much more coverage than small and micro cap stocks. 

Does analyst coverage affect your investment choices? Research indicates that it probably does. 

Source: Flickr / IntangibleArts.

One way to look at the question is to ask what happens when a company loses analyst coverage. A recent paper published in the academic journal The Accounting Review finds that these stocks tend to experience reduced trading volumes, less institutional investor interest, and a widening of bid-ask spreads.

What they don't find is a drop in the companies' economic performance. 

The Importance of Familiarity
In other words, people lose interest in stocks that aren't getting a lot of attention, and the pricing of these stocks changes as a result -- even if there isn't an investing-based reason for it. 

You might be unfamiliar with Greene County not because of its merit as an investment.Think about it. You've probably heard of Bank of America, which is the Motley Fool's most popular banking stock. Maybe you even own some shares. But have you heard of Greene County Bancorp ? Probably not. 

I like the bank primarily because it's in the business of being a bank: Nearly 80% of its income comes from interest, and noninterest income comes chiefly from account service charges and debit card fees.

The bank's balance sheet is understandable, which is another advantage over megabanks like Bank of America, which earns only 45% of income from interest and is far from simple.

Source: Flickr / George Pauwels.

Even the Fed can't keep track of the intricacies. 

Whatever your position on these particular banks, it's important to remember that analysts don't necessarily pay attention to good stocks at the expense of bad ones.

It's not an illusion: Even companies going public are highly aware of this. Highly rated analysts can bring in more underwriting business, and there is evidence to suggest that firms actually underprice their IPOs in order to get more attention from top analysts. But they do routinely pay attention to big and popular stocks at the expense of small and less popular ones. 

Overcoming Familiarity
Want to benefit from mass psychology? There is evidence that unpopular stocks tend to outperform their more popular peers.

In a sample of 1,500 companies, the authors of the book The Psychology of Investing found that surprise news -- good or bad -- helped unpopular stocks outperform the market by about 4% per year. Good news generated an enormous 8% outperformance.

Source: Flickr / Tax Credits.

Investing Like a Fool
Of course, smaller stocks, which are the least likely to be heavily covered, can be more volatile and more difficult to value than larger ones. Less information can lead to less accuracy and more risk.

Aswath Damodaran, a professor at the NYU Stern School of Business, recommends three strategies: First, focus on diversifying across stocks. Second, don't forget to do your due diligence -- research and a clear head will serve you well. And third, be patient by keep a long time horizon.

Remember, the easiest way to fix a psychological quirk is to become familiar with it.

If you know that you're poring over Bank of America just because you're hearing about it all the time, then maybe next time you'll stop yourself and start investigating some of the other banks that don't get so much attention. 

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The article Why Following The Herd is Making You a Bad Investor originally appeared on Fool.com.

Anna Wroblewska has no position in any stocks mentioned. The Motley Fool recommends Bank of America. The Motley Fool owns shares of Bank of America. 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 Motley Fool has a disclosure policy.

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