It’s easy to get anxious as an investor. It’s especially easy to get anxious when war breaks out in Europe, stock markets are tumbling, inflation is soaring, and the Federal Reserve is raising interest rates to quench that inflation.
So what do many investors do in times like these? While we like to think that we’ll be robust individualists and forge our own path, all too often we instinctively look around to see what everyone else, the big lowly herd of investors, is doing. And then many of us will join that flock.
Being cautious in the financial markets seems to make sense. We have been taught that the “wisdom of the masses” will save us because the collective wisdom is said to be greater than our own. That’s an especially comforting thought in turbulence like the one we’ve been experiencing lately. But caution – based on “collective wisdom” – almost never saves us and almost always hurts long-term investment results.
Guarding increases when the mental energy required to process what the market is doing is higher than normal, as it would be during a bear market. It’s then easy to believe that other investors have figured things out that they aren’t confused. Concerned investors believe that other investors are better informed or better able to understand volatility and competing market narratives.
One example of financial herding for which researchers have data occurred during the 1997-1998 Asian economic crisis. Asian stock markets collapsed and panicked investors sought advice from others they assumed were better informed and then followed suit. Based on broker account data for investors in Korea, even some of the strongest-willed investors who haven’t shown herd behavior in recent history have thrown up their hands and joined the herd, selling shares for whatever they can get.
But from November 1997 to May 1998, Korean investors who avoided herding — we might call them contrarians — enjoyed a return that was 9 percentage points higher than for herd investors.
John Maynard Keynes, arguably the most famous economist of all time, described the damage that herd behavior can do with the reticent manner of an academic when he said: “There is no clear empirical evidence that investment policies are socially beneficial (i.e. herd behavior) is consistent with what is most profitable.”
His speech was bloodless, but his conclusion is clear; Keynes knew that animal husbandry sometimes drives prices to extremes. He was referring to the South Sea Company bubble of 1720, but look at the internet bubble of 1999, when investors who had just managed to get online themselves were trying to understand the new technology and saw how others were — who they assumed were better informed — dodgy stock companies bought and joined.
They were wrong, and some of the hottest issues that were so voraciously bought in 1999 now make up a rogue gallery of the worst investments of all time. Whether it’s Pets.com, Webvan or Myspace, these have never been bought for the strength of their investment fundamentals, but rather for hope and caution.
The same has happened more recently with “meme” stocks such as GameStop GME, +6.71% and AMC Entertainment AMC, +0.05%.,
which, despite its ostensible focus on entertainment, recently announced inexplicable plans to use some of that “meme money” to buy a large stake in a small, financially dodgy gold mining company. AMC Entertainment’s foray into the not-so-fun business of gold mining is possible because today’s herding is supercharged by social media, allowing us to see so much more of what the herd is doing.
Beware also drives prices too low during bear markets and crashes. Beginning in June 2008, equity fund investors were net sellers of holdings for nine of the subsequent ten months. They continued to sell after the Lehman Brothers bankruptcy and continued to sell through February and March 2009 when the market bottomed.
Investors who sold their shares when Lehman Brothers filed for bankruptcy in September 2008 certainly gave themselves a pat on the back in March 2009 as the S&P 500 SPX, +0.51%, was down another 43%. But how many investors sold in September 2008 and bought back shares in March 2009? Based on stock fund flow data, very few. As a group, investors who began selling in June 2008 only bought back their shares after the market had recouped the post-Lehman loss and only because the herd was going the other way.
William morning
One reason herding is so expensive is that it limits an investor’s choices to those he sees in others. Herding can become doubly expensive because, with hindsight, it sometimes seems like the right course of action. But this is another behavioral bias, a trick we play on ourselves for remembering when things worked out — like exiting the stock market immediately after one of only four remaining US investment banks went down the drain — and forget that we did it. Don’t re-enter the market until it has regained all that ground and more.
We can’t shut ourselves off from the world and avoid all knowledge of what others are doing, so how can investors avoid the worst effects of being cautious? It’s probably the best way to understand the insidious effects of herding on our decision-making, and to ask ourselves if that’s what drives us.
Understanding our tendency to herd is the first step to making better decisions. For, as Charles Mackay wrote in his book Memoirs of Extraordinary Popular Delusions and the Madness of Crowds, which was the first real study of investor herding: “Men, it has been well said, herd thinkers; they will be found going mad in flocks, slowly and one by one regaining their senses.”
Scott Nations is President of Nations Indexes, an independent developer of volatility and options strategy index products, and author of The Anxious Investor – Mastering the Mental Game of Investing. Follow him on Twitter @ScottNations.
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