Investing requires a delicate balance of individual thought and research. Now don’t get me wrong, it can be extremely beneficial and lucrative to follow the herd at times. However, using a herd mentality 100% of the time can only lead to problems…
Similarly, blindly following the lead of others or current market trends can lead to trouble as well. Following the herd is a type of group behavior in which individuals follow the thoughts or decisions of those around them.
In the world of stocks, this often occurs simply because investors are afraid to miss out n a large payout when choosing their own path rather than following what the majority of investors are betting on.
A good example of herd mentality can be seen in the price of Tulips during the Tulip Mania bubble of Holland in early 1637 (as seen in the graph below).
Classic Herd Mentality Story
It was the first recorded economic bubble, although I am sure there were plenty before and I know there have been many since (and will continue to be many in the future). This is probably the greatest bubble story of all time which is why I want to share it with you today as a reminder of what happen when one speculates—when rational minds become lemmings.
The tulip bubble in Holland peaked in 1637. During this time, the peak of the tulip bubble, it was reported that a single tulip bulb sold for many times the annual wage of a skilled worker. At the height of the bubble, it was said that you could trade a single tulip for an entire estate, at the bottom, the tulip was the price of an onion.
Tulips were first introduced to the Dutch from Turkey in 1593. It was a highly sought after flower because of its novelty which made it pretty pricey already. Eventually, the tulips contracted a virus known as mosaic. This mosaic virus did not kill the tulips, but altered them to a degree causing “flames” of color to appear on the pedals, thus giving it a new and unique look compared to the other tulips. The flames were all different which added to the uniqueness even more. Helping add to the “price” people were willing to pay for what others were buying and flaunting.
Like the people buying tulips or trading estates for tulips, participants in the stock market are attracted to the excitement of speculation, especially when buying new things that the rest of the herd is buying.
Now think for a moment…does any of this sound familiar? I am sure it does. To me, it sounds strangely similar to the Market crash of ’87 (derivatives), junk bond crises in the early 90s, internet bubble crash in 2000, and real estate and CDO crash of 2008. I am sure there will be another one again, but I am not in the game of predicting market crashes.
Choosing To Ignore Your Instincts
Sure, investing takes more than intuition. Many of our decision making abilities are shaped by the experiences we have encountered in life already. But it doesn’t have to be that way. When you’re learning how to invest you start to develop a system for your own style of investing; this means that you make decisions based on information that comes in and the outcome will be determined by the knowledge that you’ve gained and the instincts you feel in regards to the data.
Listen to the greats. Or as they say, “learn to stand on the shoulders of giants.” This will help get you to where you need to go faster because success leaves clues. However, it is up to you to create your own philosophy and system of investing as time progresses. Never foolhardily run into and out of stocks because someone said something or because someone else was doing it.
By reacting to the conditions of the market, rather than what others in the stock market are choosing to spend their money on you will find yourself making more level-headed decisions. Remember the market is there to SERVE you—not GUIDE you. Don’t let the herd dictate your decisions, usually they don’t know any better themselves. They are just going with the flow, or dare I say, the trend.
How Would You Advise Someone On Their Investing?
When you really sit back and think about how herd mentality is effecting your investments, consider how you would advise a loved one in other money spending efforts. Would you suggest that other family members put all of their hard-earned dollars into a certain project or investment blindly simply because others were choosing it? Or would you suggest that they do their due diligence and research that choice before making a decision?
We all know the answer to these questions. Yet, individuals invest and trade blindly every day with the trend of the herd. Investing in businesses without proven track records and deteriorating fundamentals will surely end in dismal failure. Choosing a stock of the moment rather than a well thought out investment can often be like getting your hair cut to suit a current crazy fad. It might seem like a good idea in the moment, but when you begin to see the error of your ways you’re left with only a bad haircut.
Unfortunately, in the stock market there’s more than hair on the line, and many people lose large sums of money due to errors made by blindly following the herd.
But Everyone Else Is Doing it…
It’s comforting to make choices that everybody else is making because there is a certain feeling of safety in being a part of a large group. While it’s sometimes results in success, failure is still a possibility (and highly probable) when following the trend. One of the reasons so many people use this method of investing is even if the results are mediocre or cause some losses, one can try to counter the negative effect on one’s emotions by arguing that most people were affected by it too. You weren’t the only one.
This is very similar to the relative performance game that fund managers are notorious for on Wall Street. Personally, the concept of relative performance confounding is to me. You can’t spend relative performance. If you lose 20%, but the market loses 25%…it doesn’t make it “good” because you beat the market. You still lost money.
The many “experts” on Wall Street sell and promote momentum and current market trends. This helps to advance the ‘group think’ mentality, which leads others in the market place to all jump on the same bandwagon. And of course, this leads to mediocre investment returns as a result.
Some of the strongest investors around, such as Warren Buffett, have gone against the group by buying when many wouldn’t get involved, and have been successful by selling when markets became stable again. There are times when it seems logical to go along with decisions made by the herd, especially if that’s what your instincts and past experience are telling you to do. However, there is a caveat here too:
The market is actually efficient the majority of the time…
Now, I’m sure you’re thinking, “Wait!?!?! You just said don’t follow the herd…”
Yes. It is true. I said “don’t follow the herd.” But I also said don’t follow the herd all the time.
During times of extreme market optimism and euphoria, you need to be very careful and cognizant of the market you are investing in especially at inflection points. The market can also provide opportunity in the form of less popular, “boring” high quality businesses as the market participants rush to the cool and popular stocks.
Just look at this study by James Cullen. He stated, “$1 million investing in the Standard & Poor’s-stock index in 1968 would have been worth $79 million by the end of 2013. But $1 million invested in the 20 percent of the S&P 500 with the lowest price-to-earnings ratios would have been worth $578 million…On an annualized basis for the period from 1968 to 2012, growth stocks (top 20 percent of the S&P 500 based on P/E ratios) returned 7.9 percent, while value stocks returned 13.8 percent,” according to Mr. Cullen’s research.”
In fact, over 46 rolling five-year periods only four times did growth stocks outperform value stocks. This shows you that you can achieve investment success, as well as a boat-load of cash by not following the herd (all the time).
So Do You Follow The Herd…?
The idea of buying trending/momentum stocks is very popular in the marketplace (Which is why it doesn’t work long term). And it sounds easy, doesn’t it?
They tell you all you need to do is just keep buying something that continues to go up in price or keep selling something that continues to go down in price.
Here is the quandary—How do you know when the momentum has stopped? Or when it is about to stop?
Let’s say Mike, an accountant, decides to start investing for his retirement and grow his wealth. He decides to buy a popular stock from a business that makes headlines every day and is highly touted by Wall Street. He purchases the stock as it reaches 52-week highs and he figures he is missing out on the move of a lifetime if he doesn’t get in Right Now!
The stock has risen from $20 to $90 already, and Mike finally “invests” in the stock at $90. He is excited. The stock keeps rising…it hits $92…then $95…and then $100. Mike is ecstatic.
So he keeps buying the momentum and positive story growth stock regardless of fundamentals. The stock falls 5% and he sells thinking the momentum is fleeting. He read that in a trading book somewhere and Jim Cramer said he wasn’t very interested in the stock anymore—so it’s got to be the right thing to do. Right?
So Mike makes a little profit and he is feeling really good about it. This stock is talked about positively onthe news everyday still. The stock rises again, makes new highs, and he buys again.
This time he buys at $110, and shortly after his purchase the stock drops 10%!?!?!
He says to himself, “What the F*#*? What am I doing wrong? Why is it not going up? I am a good person, why is this happening to me?”
So this time he holds on and buys more, thinking that momentum will once again come back. I mean, it has to right?
He makes a silly justification and thinks, “there’s got to be more buyers out there, it’s a very popular stock.”
But the stock continues to fall. The stock was priced for perfection: trading at > 100x earnings and reaching market maturation. However, the market and Wall Street modeled it for continued and consistent growth and profitability at current levels. Rarely does that happen. Mike soon comes to the realization that he was too enthusiastic, too emotional, and made a major mistake.
He finally sells that stock at $50, thus locking in his permanent losses.
And of course, as luck would have it, 6 months later the stock rose to $100 again. Mike is beyond frustrated and wants to give up on investing and growing wealth.
He made a common and major mistake in investing: Purchasing a stock priced for perfection.
A stock that is fully priced by the market will fully correct in the market. The moral of the story is stay away from momentum and herd behavior. When I say momentum and herd behavior I am talking not only talking about stocks, but also index and mutual funds, as well as other forms of private capital investing.
See the graph below of the typical investor’s psychology.
Don’t invest with the herd!
Investing in NON-momentum stocks can be quite difficult for many individuals. However, this is exactly what we must do in order to achieve out-sized returns over the long-term. You can see how lucrative it is for the individual investor. There are a number of physiological reasons for this perverse mentality. Perhaps as humans we love to buy positive stories; or maybe we go back to our roots and just want to run with the rest of the herd; or maybe it’s because we look at the readily available data (charts) instead of what matters most—the intrinsic value and future earnings ability of the business.
It is normal human nature to look at past performance to help us figure out future returns. However, just because a stock or fund has done well over the last 1-3 years, doesn’t mean it is a good time to invest Right Now.
In fact, it usually means the complete opposite.
According to a recent study by Vanguard Group, “on average, 39% of funds with 5-star ratings outperformed their style benchmarks for the 26 months following the rating, while 46% of funds with 1-star ratings outperformed their style benchmarks for that period…the top-rated funds are shown to have actually generated the lowest excess returns across time, while the lowest-rated funds generated the highest excess returns.”
A five-star rating is usually given to funds that have performed the best over the last one to three years. Based on this study, you can see it doesn’t pay as well to follow momentum and the herd.
As humans we sometimes seem to have this fascination with overly complicating matters. Nowhere is this more evident than investing the stock market.
In addition, herd mentality investing can occur in all types of markets, not just the Stock Market. It can happen in private equity, angel and venture capital deals as well, however, herd mentality is rampant in markets in which everyone can have access. Private equity, angel and venture capital can become crowded at times, and they have each gone through their own boom-and-bust cycles. However, these markets are closed off from normal, everyday folks, so they are probably less prone to the folly of the public markets.
Based on the Tulip Mania example and the study by Vanguard, you can now see how herd behavior and trend following is not usually a very profitable investment strategy. Buying and selling based on the latest fads and shiny objects of Wall Street will make it very difficult to compound your wealth over the long-term.
It’s tempting, I know.
However, an investor will be better served to steer away from the herd even though it may be difficult and painful to do so. This is where your out-sized returns will come from over time.
Patience Will Pay.
Cullen, James P. Investment Strategy: Melt-up Market (update).
Phillips, Christopher B. and Kinniry Jr., Francis M. Mutual Ratings
and Future Performance. http://www.vanguard.com/pdf/