Follow the herd?

Follow the herd?

January 25, 2022
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The past decade has seen an incredible shift in how we receive news and how quickly we can receive that news. While the internet has been increasing the speed of information for decades now, the explosion of social media has pushed the envelope much further. For better and often for worse, news travels much more quickly than word of mouth. This is even the case when talking about news between just two parties. A great example of this is the growing number of NBA players learning they have been traded via reports on social media rather than getting a call from their bosses in the organization. Outside of the flow of news also is the increasing visibility and compliance of trends. Maybe compliance is a bit of a robotic word to use, but that is really what can be seen today. Everyone wants to jump on trends, and no one wants to be the person that misses out on the opportunity to be a part of something bigger than themselves. FOMO, fear of missing out, plays a large factor here as well. So where am I going with this? This herd mentality can be seen within investing as well and there are some pretty relevant examples.

Herding mentality bias as it is named is the belief that if so many people are doing the same thing then how can all of them be wrong? From the outside looking it is easy to note that lemmings have the same thought before their impending doom. In the same way, herding mentality can hurt your investments. It is easy to want to jump on the trends without having any knowledge of what you are investing in. For instance, there are millions of people pouring billions of dollars into cryptocurrency when they have no idea how the block-chain works. I am not at all saying that you shouldn’t invest in crypto and experiment with all of the new types of investments that our free market has to offer. What I will say is to be careful. We all have to try to take off our biased lenses and look at things for their face value. I find my investment wins more rewarding when I did the research beforehand and had a reason to put my money into an investment. Conversely, I find it easier to accept losses on investments that I genuinely had reason to believe they would succeed, but they simply did not. This fundamental stock analysis is a rational way of going about portfolio building. Efficient market hypothesis believes that this is how all buyers evaluate their investment decisions. However, efficient market hypothesis does not always hold true in our market today.

A bit of explanation of EMH is necessary before we move forward. As I somewhat mentioned earlier, EMH states that because all information regarding a stock is available the price buyers are willing to pay for a stock must be its Fair market value. The problem with this theory is that it gives investors too much credit. We are painted as much more rational creatures than we are. The truth is we are fairly irrational, and when we join together we can irrationally influence stock prices very easily. This can be seen very clearly in the work of Wall Street Bets. Wall Street Bets is a social media group on Reddit that discusses stock picks and trading. Currently the group has 11.5 Million members. If the name sounds familiar to you, it is probably because they have been in the news a lot lately, specifically for their influences on GameStop and AMC stock. In short, the administrators of this group are known for instructing their copious amounts of members to buy obscure stocks and thus cause their prices to skyrocket. They coin this process as sending a stock “to the moon”. Now, do these companies have reason for these massive gains other than the shout out from Wall Street Bets and their herd of followers? No, in my opinion GameStop was simply used as a ploy in an attempt drive a hedge fund out of business. However, buyers of the stock at the time of the buy command paid $20 for the stock which at one point rose all the way to $480. The stock price is now down around $89. All this volatility because of herd mentality.

So what exactly can we take away from herd mentality in our investing lives? While following the herd on investment choices can be the right choice, it is always wise to have reasons for doing so. Don’t hesitate to run your reasoning by someone else first to see if you’re thinking clearly. It’s very possible that the herd is right and it is time to jump on the bandwagon. Very possible also is it that the herd is running towards a cliff and they don’t even realize it. It may be prudent to follow near the herd without actually being in it.

Song

 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

All investing involves risk including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.