Investing Insights: How to Profit From Mob Psychology

This is a sponsored column by 3Summit Investment Management, LLC based in Vienna, VA. 3Summit designs custom, modern investment portfolios and has unique expertise in managing investment risk.

By Dan Irvine | Principal, 3Summit Investment Management

This is not a fashion column; we are here to talk about investing.

But have you ever thought about what influences your fashion decisions? How many times have you looked back at old pictures and laughed at the clothes they were wearing? No one wants to be thought of as a follower, but that is probably the reason for your questionable fashion choices of the past… everyone else was wearing the same thing.

Humans are pack animals; we are tribal beings. Mob psychology, our innate drive to follow the crowd, influences not only our fashion decisions but also our investment decisions. Our tendency to follow the pack has been key to our evolutionary success, but also makes us terrible investors by default.

Unfortunately for investors, instinct usually wins out over smarts. Despite our self-awareness, we cannot prevent ourselves from being influenced by mob psychology when faced with the powerful emotions of fear and greed that we experience when making investment decisions.

While the impact of mob psychology is the source of most investors’ losses and biggest investment failures, for the well-informed, disciplined investor, mob psychology is a fantastic and robust source of superior, long-term investment returns.

An Investment Strategy Designed to Profit From the Crowd

While impossible to prove, human psychology and our tendency to follow the herd is almost certainly the primary driver of stock market price movements. Humans are highly irrational when fear or greed lead us to follow the crowd, our irrational behavior make financial markets impossible to predict.

However, what we can predict is the certainty that market participants will continuously succumb to mob psychology, this behavior with ultimately drive a new boom and bust cycle that we see repeat over-and-over again in financial markets.

Trend following is a time-tested quantitative investment strategy that seeks to systematically profit from mob psychology by identifying trends in price movement, up and down, and then investing with the trend when investors are greedy and exiting the market when investors are fearful.

Trend following is a form of momentum investing in that when the price of a security is in motion in one direction the price tends to remain in motion in that same direction. Price momentum is driven by the human tendency to follow the crowd.

For example, when one stock is outperforming most other stocks, investor greed lures investors to buy the outperforming stock with the hope of making outsized profits. When investors pile into the same trade on a large scale, the result is significant upward price momentum that is completely detached from the fundamentals of the individual company that the investor is investing in.

Trend following is not a method of predicting stock market movements. The objective of trend following strategies is to identify when a strong upward price trend has been established, then to follow the crowd into the trade. As soon as signs appear that price momentum is slowing or reversing direction, the strategy then quickly exits the trade and cuts losses to protect from the potentially very large losses stocks are prone to delivering.

3Summit considers trend following to be an essential component of a well-designed, diversified portfolio. Trend following strategies usually have low correlations to other stock strategies, but also, they add a unique source of returns that contribute to helping a diversified portfolio produce more consistent returns over time.

High quality trend following strategies add many other benefits to a portfolio including being capable of producing enhanced returns, protecting portfolios from large losses, insulating portfolios from behavioral bias by removing human discretionary decision-making and strategically shifting a portfolio’s exposure between domestic and international stock markets.

Trend following concepts have been used for more than a century by some of history’s most famous traders, however, advanced technology and the ability to process large volumes of data quickly have aided in the speed and effectiveness of modern trend following strategies. Trend following strategies provide a systematic approach to cutting your losses short and letting your winners run.

Learn More

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3Summit Investment Management is a fiduciary, fee only investment advisor providing clients with an alternative to outdated, conventional investment portfolios. We design custom, modern portfolios capable of delivering greater wealth accumulation with much lower levels of risk. To learn more about how we can help you improve your long-term investing results call (571) 565-2161, email ([email protected]) or visit 3Summit.com.