Getting Trampled by the Herd
October 18, 2012

Many people are programmed to assume the consensus view is the correct one. They see a particular movie based on a number of positive reviews, buy a particular phone because people have camped out in front of a store to get it, or change their hairstyle based on the latest fad. It’s extremely hard to go against the crowd, even if you can’t afford that fancy new phone, or that new hairstyle isn’t actually so attractive on you. It may be easy to laugh off falling prey to a gadget trend or a hairstyle, but what happens when it’s your investments that have been trampled by following the herd? Being hard-wired to follow the herd probably serves some evolutionary survival purpose, but when it comes to investing, mustering the strength to break from the crowd may actually be the superior survival technique. We continue our exploration of behavioral finance with the concept of “herding” as it applies to investing.

Some key thoughts:

  • Following the crowd often means buying when prices are too high and selling when prices are too low.
  • Value-hunters may be able to find equity bargains when others are moving out of equities.

Herding: We are programmed to feel the that the consensus view must be the correct oneThe problem with following the crowd when it comes to investing is that often investors buy when prices are too high, and sell when prices are too low, a phenomenon known as “chasing the market” and not exactly a sound investing practice. The word “contrarian” has a surly ring to it, but the idea of zigging when others are zagging is actually the foundation of the basic buy low/sell high investing strategy.

When the majority of investors are strongly pessimistic, the entire market can drop. As investors run for the exits, individual companies, when considered outside the mass hysteria, may actually appear to have solid fundamentals. If not for the market noise, these companies might even look pretty darn good. Sure, when sweeps like this happen, it can also help to clean house, ridding the market of companies not strong enough to survive. But what about the others? This is where value-hunters can often find great bargains.

The late Sir John Templeton had plenty to say about this type of behavior. One of his more famous lines:

“Avoid the popular. When any method for selecting stocks becomes popular, then switch to unpopular methods.”  

It’s Time to Take Stock

Let’s look at an example of this herding behavior in practice in the markets today. “Flow” is an industry term used to describe how investors allocate cash toward various asset categories. If flows are negative for a particular asset category (equity funds, for example), it means investors are taking more money out of that category than they’re putting in.

Over the last four years, net flows into equity funds were essentially flat or negative, which can be attributed, at least in part, to market volatility; investors have been skittish about equities. As investors pulled money from equity funds, the amount of cash on the sidelines had grown to $5.8 trillion by March 31, 20121.

 

However, sitting on the sidelines can come at the cost of lost opportunities and potential yield. So how can investors change their behavior and avoid this pitfall?

To shed further light on how our behaviors shape our decision-making process, we had the opportunity to speak with Dan Ariely, James B. Duke Professor of Psychology and Behavioral Economics at Duke University and author of The New York Times best seller, “Predictably Irrational: The Hidden Forces That Shape our Decisions.”

In the world of behavioral economics, Ariely says mechanisms put in place to prevent undesirable future behaviors are often called “Ulysses Contracts.” Based on Greek mythology, the idea is to create barriers today that prevent you from taking actions you know you’ll likely regret later on—such as avoiding the mistakes others make to their detriment.

“Ulysses knew that when the Sirens would come calling, he would sail off course to his peril. So he asked his ship’s crew to tie him to the mast, and put wax in their ears, so he could hear the Sirens but couldn’t act on temptation, and they couldn’t hear the temptation but could still navigate the ship.”

The lesson in all this is that when the herd starts stampeding in one direction, you might want to consider seeking out a new one. Consider your alternatives, such as diversifying your investments when markets have run up, looking for values when markets have declined, or seeking out potential income-generating assets you might not have considered before. Your advisor can help you uncover the ideas and tools that work for you. Become a contrarian thinker and who knows, you might find yourself leading the pack.

Learn more about why following the herd may not be the best course of action by visiting our new 2020 Vision: Time to Take Stock website.

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What are the Risks?

All investments involve risks, including possible loss of principal. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions.

 


1. Source: Money Market Accounts and CDs (Time Deposits at FDIC-insured commercial banks and savings institutions): FDIC. As of 3/31/12.

 

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