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

It’s easy to become anxious as an investor.  It’s particularly easy to become anxious when war is erupting in Europe, stock markets are gyrating, inflation is spiking, and the Federal Reserve is raising interest rates to snuff out that inflation. 

So what do many investors do in times like this?  While we like to think that we’ll be rugged individualists and go our own way, too often we reflexively look around to see what everyone else, the great lowing herd of investors, is doing.  And then many of us will join that herd.

Herding in financial markets seems to make sense.  We’ve been taught that the “wisdom of crowds” will save us because the collective wisdom is supposedly greater than our own.  That’s an especially comforting thought during turmoil like that which we’ve experienced lately.  But herding – relying on “collective wisdom” – almost never saves us and nearly always hurts long-term investment results.

Herding increases whenever the mental energy required to process whatever the market is doing is higher than normal, as it would be during a bear market. It is then easy to believe that other investors have things figured out, that they’re not confused.  Anxious investors imagine those other investors are better informed, or better able to make sense of the 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 panicky investors looked to others, who they assumed were better informed, for guidance and then followed their lead.  Based on brokerage account data for investors in Korea, even some of the strongest-willed investors, those who had not displayed herding in the recent past, threw up their hands and joined the herd by selling shares for whatever could be got for them. 

Yet from November 1997 through May 1998, those Korean investors who avoided herding — we could call them contrarians — enjoyed returns 9 percentage points greater than for those investors in the herd.

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

His language was bloodless but his conclusion is clear; Keynes knew herding sometimes drives prices to extremes.  He was referring to 1720’s South Sea Company bubble, but look at 1999’s internet bubble, when investors who had just managed to get online themselves sought to make sense of the new technology and saw others – who they assumed were better informed – buying shares in dubious companies and joined in.

They were wrong, and some of the hottest issues being bought so voraciously in 1999 now make up a rogue’s gallery of the worst investments of all time. Whether it’s Pets.com, Webvan, or Myspace, these were never bought because of the strength of their investment fundamentals but instead because of hope and herding. 

The same has happened more recently with ‘meme’ stocks like GameStop
GME,
+0.99%

and AMC Entertainment
AMC,
-2.46%
,
which despite its purported focus on entertainment recently announced inexplicable plans to plow some of that “meme money” into buying a major stake in a small, financially dubious gold miner. AMC Entertainment’s foray into the not very entertaining business of gold mining is possible because today’s herding is supercharged by social media, which allows us to see so much more of what the herd is doing.

Herding also drives prices too low during bear markets and crashes. Beginning in June 2008, equity mutual fund investors were net sellers of holdings during nine of the following 10 months.  They continued selling after the Lehman Brothers bankruptcy and were still selling in February and March 2009, when the market was at its bottom. 

Investors who sold their stocks when Lehman Brothers filed for bankruptcy in September 2008 were certainly patting themselves on the back in March 2009, because the S&P 500
SPX,
+1.43%

had dropped another 43%.  But how many investors sold in September 2008 and bought shares back in March 2009?  Based on equity mutual fund flow data, very few. As a group, those investors who started selling in June 2008 didn’t buy back their shares until well after the market had recovered the post-Lehman loss, and only because the herd was headed in the other direction. 

William Morrow

One reason herding is so expensive is because it limits an investor’s alternatives to those they see others using. Herding can be doubly expensive because it occasionally seems, in retrospect, to 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 bailing out of the stock market immediately after one of just four remaining U.S. investment banks goes belly up – and forget that we didn’t get back into the market until after it had regained all that ground and more.

We can’t shut ourselves off from the world and avoid any knowledge of what others are doing, so how can investors avoid the worst effects of herding?  It is likely that the best course is to understand the insidious impact herding can have on our decision-making and ask ourselves if that is what is driving us. 

Understanding our tendency to herd is the first step toward making better decisions.  Because as Charles Mackay wrote in his book “Memoirs of Extraordinary Popular Delusions and the Madness of Crowds,” which was the first real study of herding among investors: “Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.”

Scott Nations is the president of Nations Indexes, the world’s leading independent developer of volatility and option strategy index products, and the author of “The Anxious Investor – Mastering the Mental Game of Investing.” Follow him on Twitter @ScottNations.

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