Following the Sheep to Slaughter

DEFINITION of ‘Sheep’

An investor who lacks a focused trading strategy and trades on emotion and the suggestions of others, including friends, family and financial gurus. This type of investor often makes rash investments without first determining whether these decisions are financially viable. The behavior of sheep contrasts with that of bulls and bears, who have focused views about the market.

“People change when they join crowds. They become more credulous, impulsive, anxiously search for a leader, and react to emotions instead of using their intellect.”

Perhaps no where is the strange effect is the psychology of crowds seen than in the financial markets. One of the more recent examples as I have spoken about in my other lessons of the effect that the psychology of crowds can have on the markets is the run-up of the NASDAQ into 2000. As you will find by pulling out the history books however, this is not an isolated incident as financial history is littered with similar price bubbles created and then destroyed in the same way as the NASDAQ bubble was.

From a primitive standpoint chances of survival are often much higher as part of a group than they are alone. Similarly war’s are often one by militaries with the strongest leaders. It is thus only natural to think that humans desire to survive would breed a desire to be part of a group with a strong leader into the human psyche.

So how does this relate to trading? Well as we learned in our lessons on Dow Theory, the price is representative of the crowd and the trend is representative of the leader of that crowd. With this in mind think about how difficult it would have been to short the NASDAQ at the high’s in 2000, just at the height of the frenzy when everyone else was buying. In hindsight you would have ended up with a very profitable trade but, had the trade not worked out, people would have asked how could you have been so dumb to sell when everyone else knew the market was going up?

Now think about all the people who held on to their positions and lost tons of money after the bubble burst in 2000. As they had lots of company there were probably not a whole lot of people who were laughing at them. Yes they were wrong but how could they have known when so many others were wrong too?

By looking at this same example, you can also see how panic selling often ensues after sharp trends in the market as this is representative to a crowd whose leader has abandoned them.

In order to trade successfully people need a trading plan which is designed before entering a trade and becoming part of the crowd so they can fall back on their plan when the emotions which are associated with being part of a crowd inevitably arise. Successful traders must also realize that there is a time to run with the crowd and a time to leave the crowd, a decision which must be made by a well thought out trading plan designed before entering a trade.