Opinion: The ‘wisdom of crowds’ can cost you dearly when the stock market is in turmoil

It’s easy to get anxious as an investor. It’s particularly easy to get anxious when war breaks out in Europe, stock markets turn, inflation soars, and the Federal Reserve raises interest rates to quell that inflation.

So what do many investors do at times like this? While we like to think that we will be hard-core individualists and go our own way, too often we reflexively look around to see what the others, the great herd of investors, are doing. And then many of us will join that pack.

Herding in the financial markets seems to make sense. We have been taught that the “wisdom of crowds” will save us because the collective wisdom is supposedly greater than ours. That’s an especially comforting thought during upheaval like the one we’ve been experiencing lately. But herding, which relies on “collective wisdom,” almost never saves us and almost always hurts long-term investment results.

Grazing increases whenever the mental energy required to process whatever the market is doing is higher than normal, such as it would be during a bear market. So it’s easy to believe that other investors have things figured out, that they’re no confused. Anxious investors imagine that those other investors are better informed or better able to understand the volatility and narratives of the competitive market.

An example of financial shepherding for which researchers have data occurred during the Asian economic crisis of 1997-1998. Asian stock markets tumbled and panicked investors looked to others, who they assumed were better informed, for guidance and then followed suit. Based on data from investors’ brokerage accounts in Korea, even some of the strongest-willed investors, those who hadn’t shown shepherding in the recent past, gave up and joined the herd by selling shares. for what he could get for them.

However, from November 1997 to May 1998, Korean investors who avoided the herd (we might call them contrarians) enjoyed returns 9 percentage points higher than investors from the herd.

John Maynard Keynes, probably the best-known economist of all time, described the harm that herding can cause in the understated manner of an academic when he said: “There is no clear evidence from experience that investment policy that is socially advantageous (i.e. grazing) coincides with the one that is most profitable.”

His language was bloodless but his conclusion is clear; Keynes knew that herding 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 gotten online sought to make sense of new technology and saw others, who they assumed were better informed, buying shares in dubious companies and joined.

They were wrong, and some of the hottest topics that were so voraciously bought in 1999 now form a gallery of crooks with the worst investments of all time. Whether it’s Pets.com, Webvan or Myspace, these were never bought on the strength of their investment fundamentals, but on hope and grazing.

The same thing has happened more recently with ‘meme’ stocks like GameStop GME,
+0.99%
and AMC EntertainmentAMC,
-2.46%,
who, despite his supposed focus on entertainment, recently announced unexplained plans to invest some of that “meme money” in buy a major stake in a small, financially dubious gold miner. AMC Entertainment’s foray into the unentertaining business of gold mining is possible because the herd today is powered by social media, allowing us to see much more of what the herd is up to.

Grazing also drives prices too low during bear markets and dips. Beginning in June 2008, stock mutual fund investors were net sellers of shares for nine of the next 10 months. They continued to sell after the Lehman Brothers bankruptcy and were still selling in February and March 2009, when the market was at its lowest point.

Investors who sold their shares when Lehman Brothers filed for bankruptcy in September 2008 were no doubt patting themselves on the back in March 2009, because the S&P 500 SPX,
+1.43%
it had fallen another 43%. But how many investors sold in September 2008 and bought shares in March 2009? Based on equity mutual fund flow data, very few. As a group, the investors who started selling in June 2008 didn’t buy back their shares until well after the market had recovered from the post-Lehman loss, and only because the herd was headed in the other direction.

william tomorrow

One reason the herd is so expensive is because it limits an investor’s alternatives to those they see others using. Grazing can be doubly expensive because it occasionally seems, in retrospect, have been the correct course of action. But this is another behavioral bias, a trick we play on ourselves because we tend to remember when things worked out, like getting out of the stock market immediately after one of the four remaining US investment banks failed, and forgetting that we didn’t. we did it. He would not return to the market until after he had recovered all that ground and more.

We cannot isolate ourselves from the world and avoid any knowledge of what others are doing, so how can investors avoid the worst effects of herding? The best path is probably to understand the insidious impact that grazing can have on our decision-making and ask ourselves if that is 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, think in herds; it will be seen that they go mad in packs, while they only come to their senses slowly, and one by one.”

scott nations is the Chairman of Nations Indexes, an independent developer of volatility and options strategy index products, and the author of “The Eager Investor: Mastering the Mind Game of Investing.” Follow him on Twitter @ScottNaciones.

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