Don?t Follow The Herd

03.01.12

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With everything that's been going on in the Eurozone, economy and financial markets, and the media taking every opportunity to sensationalise each bit of news, it?s worth taking

With everything that's been going on in the Eurozone, economy and financial markets, and the media taking every opportunity to sensationalise each bit of news, it?s worth taking a step back and try to see the wood for the trees again.

The first question is: why should people consider investing in stocks and shares in the first place?

Companies wanting to raise new capital to expand typically have three main options available to them:

(1) Borrow from the bank and repay the capital plus interest over time.

(2) Offer investors fixed interest bonds and repay the capital and higher interest over time.

(3) Issue shares, thus effectively selling some of the company to external shareholders.

Companies opt for option 1 or 2 if they believe that they can re-invest the loan to make more money than the costs of borrowing.

They issue shares because the owners believe they can re-invest the funds to make greater net gains, even though they will own less of the business as a result.

So, the first fundamental is that equities will be expected to outperform both cash and fixed interest bonds. The second fundamental is that to reduce the risk to individual companies, investors should invest in funds run by professional managers who spread the fund assets over many companies in different sectors.

The next question is: what drives the price of the shares on any given day? The simple answer is demand and supply – how many people want to buy the shares and how many want to sell them.

It?s similar, for example, to selling a porcelain collection at an auction. A seller hopes that all the potential buyers want to buy porcelain and that they are the only one selling. Buyers hope they are the only ones buying and that there are many sellers. Competition between buyers should drive the price up, while if everyone is selling to very few buyers, this will drive the price down.

It?s similar with the price of shares: if there are more people wanting to buy shares than people wanting to sell the price will go up; if there are more sellers than buyers, the price will go down.

That?s not to say that company profit forecasts and economic results are not important. Every investor, whatever they are buying, wants to believe that they are buying something that will make them a profit over time. They are typically happy to pay over the odds for something that they feel will still make them a profit. In the case of company shares however, if the company profit announcements are lower than expected or new economic data indicates consumers may spend less, this inevitably results in investors re-considering whether they should keep or sell the shares.

This means that rather than company or economic news directly impacting the price of shares, it?s the emotions of investors who use this news to evaluate whether they should buy, sell or hold.

The herding mentality of the human race is never more evident than in the stockmarkets where we are all sellers or all buyers. Unfortunately by the time the equity buying band wagon has reached the maximum, that?s the time when markets start falling. Equally, when the market has reached the bottom, that?s when no one is buying when they should be.

Looking again at the porcelain auction example, if you wanted to sell a collection but learned that every other seller would be at the auction, you?d probably stay away. Alternatively, if you were a buyer, then surely that?s the auction you want to be at.

It?s strange and unfortunate that when it comes to stockmarkets, investors forget this logic and buy when shares look expensive and sell them when they are cheap because everyone else is also trying to sell theirs.

So, the third fundamental is that investors should not follow the herd. Those that do will generally lose out by buying shares when competition for them is high and selling at a loss when everyone is trying to sell theirs as well.

The fourth fundamental is that as a result of the human herding mentality, share market movements tend to be over exaggerated, both on the way up and way down, and are driven partly by emotion rather than logic.

So where does this leave us?

There is no denying that this is an uncomfortable time with the ongoing Eurozone crisis and poor economic news continuing to filter through, but let?s take a step backwards in order to look forward.

We are generally living longer and across the globe there is a population boom, so there is an increasing number of consumers to whom companies can sell goods and services. The industrialisation and economic growth of countries like China and India with far lower cost bases than the West allows companies to move manufacturing to cheaper markets, thus helping them improve their profits. Irrespective of the short term, these trends continue to support the view that equities remain a vital component to protecting investors? wealth (after taking account of inflation) in the longer term. In addition, interest rates remain low which enables companies to borrow for growth at lower costs.

While it is hard to escape the doom and gloom at the moment, where the herding mentality results in the wholesale selling of shares this creates opportunities to purchase equities within a wide spread and diversified portfolio at attractive prices. Buying during falling markets increases the potential for you to make a decent profit over time once markets start moving upwards.

Investors holding cash could consider investing part of their wealth in equities. Existing investors should not sell and could consider increasing their exposure to equities at this time.

With uncertainty remaining over the Eurozone we can expect share price volatility to continue for a while yet, so you should only buy shares if you are prepared to hold them for the medium term. Diversification across assets, sectors, regions and companies is key in this investing environment. It is also essential that you take your objectives, circumstances and risk tolerance into account before making any purchases.

Professional and authorised advice is a necessity in this area from firms such as Blevins Franks.

By Bill Blevins, Managing Director, Blevins Franks

21st December 2011

Tax rates, scope and reliefs may change. Any statements concerning taxation are based upon our understanding of current taxation laws and practices which are subject to change. Tax information has been summarised; individuals should seek personalised advice.

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