Follow the Crowd Strategy and Its Risks

Feb 1, 2021 08:15 PM ET
Follow the Crowd Strategy and Its Risks

Following the crowd refers to a trading strategy that involves identifying an existing trend and placing trades in that direction. It is also known as following the trend. In other words, you just spot an asset that’s trending and then trade in that direction. In case the asset’s price is rising, you just buy and profit as it rises. Similarly, if it is falling, you short and profit from the decline.

Value vs. momentum stocks

On a broader scale, in the stock market, a good way to measure the performance of following the trend is to look at value and momentum stocks. Value stocks are often large and old companies that trade at a value that is lower is below their intrinsic value. Typically, they have a price to earnings ratio that is lower than that of the S&P 500. Most of them are also generous givers of dividends.

On the other hand, Momentum stocks are those of fast-growing companies that, in most cases, don’t have a lot of profit and revenue. Instead, investors love them because of their growth and future prospects. For example, a company like Tesla is today more valuable than other automakers despite the fact that it sells fewer cars than them. These momentum or growth stocks usually rally because of the interest among investors. As shown below, the Vanguard Growth ETF always outperforms the Vanguard Value ETF. 

Vanguard Value ETF vs. Vanguard Growth ETF and S&P 500

Vanguard Value ETF vs. Vanguard Growth ETF and S&P 500

Notably, they follow the crowd or trend strategy does not apply to stocks alone. It applies to other financial assets like cryptocurrencies, currencies, and commodities. 

How to spot trends early

The secret to success when using the follow the crowd strategy is to spot these trends early. Furthermore, people who identified Tesla shares when they were trading at less than $50 have now achieved significant results. Similarly, those who bought Bitcoin when the price was below $1 have now achieved returns worth more than 40,000%. In 2020, investors who identified the strength of the dollar and the eventual decline had substantial profits. Most importantly, investors who bought shares at their lowest point in 2020 generated strong returns as the stocks soared.

Using the Dow theory

The Dow theory was developed by Charles Dow, who is credited for starting the Dow Jones Industrial Average (DJIA). The theory provides a simple explanation of how trends form. 

Precisely, he talked about primary, secondary, tertiary movements. In the first step, there is usually an accumulation, where true believers of an asset start buying. This then leads to a relatively skinny rally. It is then followed by a pullback as some of the original buyers start selling their assets. This decline is usually short-lived.

In the next step, there is a large move in the price of an asset as more buyers come in. This is usually the biggest move. Next, there is usually a pullback, followed by another relatively small rally. 

This theory can be explained well by using the overall performance of Bitcoin. As you can see below, the price had a relatively muted rally between 2015 and late 2017. In fact, a longer chart will show that this trend started when the currency was started. 

After reaching $20,000 in 2017, the currency declined to below $4,000 in 2019, and then rallied above $40,000 in 2020. 

Bitcoin price performance

Bitcoin price performance

You can see this type of performance in all types of assets. For example, in the chart below, we see that Facebook shares had a primary rally between its IPO in 2013 to July 2018. It then dropped after the Cambridge Analytica scandal and then bounced back. 

Facebook shares

Facebook shares

Understanding the macro trends

Another way of following the crowd in stock trading is to understand the macro trends of the day and find stocks that are likely to win. For example, in today’s world, some of the best-known trends are cloud computing, clean energy, fintech, cloud security, and electric vehicles. At the same time, the lagging trends are oil and gas, finance, and real estate investment trusts.

After identifying a certain trend, you need to identify the companies that are destined to win. They don’t necessarily need to have substantial revenue so long as they have grown.

For example, in electric vehicles, some of the best-known companies that you can invest in are Nio, Tesla, Kandi, Workhorse, and Xpeng. Also, you can find companies that supply these companies. For example, a company like Blink Charging is an indirect EV company because it provides charging stations.

Similarly, you can follow the crowd in fintech by looking at companies like PayPal, Square, Visa, Mastercard, and Shift4Payments. In the coming weeks, Affirm, a company that offers pay now buy later service, will also become public.

In cloud computing, you can invest in companies like Microsoft, Amazon, Salesforce, and Okta.

Using technical analysis

Another approach to following the crowd is using technical analysis. In this, you use indicators like the moving average, Bollinger Bands, and Envelopes to identify the formation of a new trend. You can then use them to determine whether to continue holding the asset or when to short it. 

For example, in the EUR/USD chart below, we see that it has been in an overall long-term bull run. As it does this, the rally has been supported by the 15-day and 25-day exponential moving average. Therefore, so long as the price is above the two averages, you can rest assured that you are in the money. 

However, when the price falls below the two averages, you can exit the trade since it is a sign that bears are coming back.

EUR/USD using EMA example

EUR/USD using EMA example

Summary

Following the crowd is an important trading strategy that has made many investors and traders successful. Cathie Wood, the founder of Ark Investments, is one of the best-known investors using the strategy. Her fund has beaten most other well-known funds for more than a decade. However, it is also a risky strategy, especially when you don’t know how to identify reversals.


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