Think following the crowd is a good idea? Guess again says Alessio Rastani
My best friend doesn’t buy stocks. However, a month ago he phoned me up to, amongst other things, ask whether I was buying Facebook.
Immediately, and perhaps more assertively than he was expecting I replied that ?I wasn’t touching it even with his money?.
He was puzzled, after all his only information on the IPO had come from a media frenzy labelling the IPO as one of the biggest investment bonanzas of all time.
But surely if everyone else is buying it, then maybe I should as well? was his reply. This conversation made me remember the ?Stupid Test?.
The Stupid Test is perhaps the finest assessment ever devised to judge whether a particular investment or trading decision is the right one, and the reason it is so effective is that it’s so simple. You don’t have to have any investment or trading knowledge at all to understand and apply it.
The stupid test, in its most basic form, was stated as below by Wall Street analyst Jeff DeGraaf:
1. It is impossible for everyone to be rich.
2. It is impossible for everyone to get rich following a similar strategy.
3. Comfortable strategies tend to attract everybody.
4. See Rule 1 to clarify the problem of Rule 3.
To put it another way, if an investment (or trading idea) sounds like easy money, then most likely you are not the only person who has thought of it. There are probably an awful lot of other people who have had the same idea as you.
Therefore, since 90% of people who play the markets lose money, there is a very high probability that the investment idea in question is not going to be a profitably one.
You see, most people don’t realise that the best trades are those that are absolutely boring, unpopular or just dead difficult. Actually, scratch difficult. Let’s say ?impossible?. That’s because it’s going against the grain of popular opinion, and establishing a position before the general population, that will net significant income.
The hoopla surrounding the Facebook IPO is a classic example of the Stupid Test in action ? and how a lot of people just failed to see this train wreck of an investment opportunity approaching. Over a month ago, before Facebook was launched on the stock market, I warned about the risks of buying the Facebook IPO, but the overwhelming hype and excitement surrounding Facebook stock should have been warning enough.
Why was that anticipation a warning? Because usually when everyone is expecting a particular market to do something, it does the opposite!
For example, if everyone is ?bullish? on a stock ? such as the investors who thought Facebook would sky-rocket in value as Google did in 2004 ? that means they have already bought. If everyone has already bought, then there is nobody left to buy. If there is nobody left to buy, then demand dries up, supply opens, and therefore the stock has to fall. That’s the way the markets have always operated, and will continue to operate.
Facebook suffered a similar fate. On the day of its launch shares peaked at $42, only to crash and bleed like a pig. Two weeks later it was trading at almost half of its original price.
But stocks are not the only ?animal? that the Stupid Test applies to. Other assets, such as precious metals, are not immune to it either.
Almost a year ago, in September 2011, I was dining at a social function when the subject turned to investing in Gold. At the time, Gold was trading at a high of $1900 an ounce, and people were asking me whether by December it would go to $2000.
I think I stunned a lot of people when I said that I was actually selling Gold as I expected its price to drop to $1650.
In fact, Gold dropped to nearly $1530 within a few weeks.
The very fact that so many people were excited about making money in Gold put my ?contrarian? mind on high alert. The unpopular and impossible trades are the ones where the most money can be made.
This is exactly why Google skyrocketed back in 2004, and why Facebook didn’t. In 2004 people still had the bitter memory of the Dot-Com crash of 2000 fresh in their minds. Web stocks were still unpopular, so when Google went public its shares were considerably undervalued.
Compare that with when Facebook went public. Not only were its shares extremely popular with the masses, but it turned out that some big players like Goldman Sachs were selling fifty percent of their holdings.
So ask yourself this question, who is the smarter investor – Goldman Sachs or the ?Average Joe? trying to make a buck? The smart money had already made their profit in Facebook, and now they were dumping it on to the herd.
But consider this. Which markets are unpopular with investors right now?
Well, as of right now Facebook stock is clearly hated by investors. The same financial media channels that were pumping the Facebook tune have now turned against it.
In addition, European stocks as a whole are deeply unpopular ? what with what is happening in Greece, Spain and the entire eurozone mess.
Precious metals have also taken a beating since last year (gold and silver are down 18 and 48 percent respectively from their highs).
The difficult trades right now are buying European stocks and Facebook stock. So if you?re saying to yourself right now ?why would anyone be crazy enough to buy them?? you may already be closer to the answer than you think. And when you get your head around that concept, you could well be on your way to becoming a truly successful investor.
For further information about trading the markets visit www.leadingtrader.com.