This is part four of a series on market psychology, specifically herd mentality. Click here for part one on decoding market psychology. Click here for part two on sentiment and fundamentals. Click here for part three on emotional investing.
Whether you manage your own investments and trades or not, the fear of missing out on returns can be intense. It’s not uncommon for investors to buy into a stock or other asset simply because it seems like everyone else is. This is often referred to as the herd mentality, and while it can offer some opportunities, it also presents some extraordinary risks, depending on when you buy in. This herd mentality often creates financial bubbles, and when those bubbles pop, it can mean disaster for your portfolio.
How could so many people be wrong?
Perhaps the basis for the herd mentality in investing is one simple question: How can so many people be wrong? It’s very tempting to jump on the bandwagon without doing any research because it seems unlikely that so many other investors and traders could possibly be wrong about something.
However, the problem may not be that people were necessarily wrong in the beginning. The key question when dealing with any asset that’s on a momentum run is simple. How high is too high? When considering the answer to this question, it’s a good idea to look at past bubbles to consider the extremes and examine what caused them to pop.
The first major bubble: tulip mania
Tulip mania, which took place in the 17th century, is widely considered to be the first recorded speculative bubble. One difference between this bubble and most financial bubbles today is that it didn’t have any significant or lasting impact on the Dutch Golden Age or its economy, and some argue that it may not have technically been a bubble at all. However, it does offer some lessons any investor would be wise to learn from today.
During tulip mania, some bulbs sold for over 10 times the annual pay of a skilled craftsman. The flowers became a status symbol and luxury item. One factor in the event was the formation of official futures markets, which first entered the Dutch economy during the 17th century. One of those futures markets was focused on the tulip market and involved tulip traders who signed contracts to purchase tulips at the end of the season.
Tulip prices grew dramatically over a number of years before they eventually plunged in February 1637. The tulip trade collapsed when traders couldn’t find any new buyers willing to pay their extremely high prices for bulbs—and so do many bubbles end when sellers can no longer find buyers willing to pay inflated prices for assets. S
ome economists have noted that the outbreak of the bubonic plague going on at the time could have played a role in the dramatic rise and fall of tulip prices. Whatever the reason for the collapse, simple supply and demand is one lesson investors can never afford to forget.
It only takes one event to trigger a cascade
Examining a more modern and less controversial financial bubble yields even more lessons investors can’t afford to forget. Perhaps one of the most notorious bubbles in recent history was the dotcom bubble, which some traders and analysts argue is happening again today, although in a slightly different form.
During the 1990s, investors poured billions of dollars into technology companies as the internet became widely adopted. The tech-heavy NASDAQ Composite Index climbed 400% between 1995 and 2000 as investors ignored fundamentals like price-to-earnings ratios. Investors were convinced that tech companies were a sure bet in terms of future profits. However, The New York Times reported in 2008 that only 48 percent of dotcom companies survived through 2004, and those that did survive saw their valuations plummet.
The downfall of the tech companies started in 2000 when Japan entered a recession, triggering a global selloff that especially weighed on tech stocks. Several other events weighed further on the sector, including an anti-monopoly lawsuit Microsoft lost in April 2000, which many viewed as bad for tech stocks in general. A series of events dragged investor sentiment on the sector further and further down, erasing $5 trillion in market capitalization within two years, the Los Angeles Times reported in 2006.
The problem with crowded positions
Studies show that when investors start piling into a particular group of stocks, things are great—for a time. Goldman Sachs said in a report this year that a basket of crowded stocks, or those which are most popular among hedge funds, outperformed other stocks. Clearly, the herd mentality worked out for investors who managed to get in early and exit while the momentum is still flowing in these companies’ direction.
However, it can be tempting to hold on to such stocks until it’s too late to take profits from the positions. Another study published in 2019 found that investors can see strong gains from momentum stocks—almost 3 percentage points in extra gains on top of the gains from those that are the least owned.
Unfortunately, the risk of volatility is much higher with crowded positions. UBS estimated that the stocks with the highest ownership among hedge funds and exchange-traded funds recorded losses that were four times the size of the S&P 500’s loss during the October 2018 selloff. In other words, when something happens that causes everyone to sell, such stocks will fall much further than others because they’re being sold more than less crowded stocks.
How to avoid the herd mentality in investing
So how can investors avoid the herd mentality when making investing decisions? The most important thing to do when considering any position is research. If it looks like everyone is piling into a particular stock, then it’s a good idea to research it before drawing any conclusions and ask why the stock is so popular. Is the company merely a passing fad, or does it have real potential to post the kinds of profits its stock price implies?
If you start with an eye on fundamentals and get out before a major event triggers a selloff, then it is possible to benefit from the herd mentality, but that can be more easily said than done. Many investors argue that a company will be able to grow into its stock price eventually, but the problem with this is that if the stock keeps rising with no respect for fundamentals, it will eventually get far too high for the company to grow into. It’s a simple matter of the law of large numbers. One sign that the herd is running away with a stock’s valuation is when people start claiming that traditional models of valuation no longer apply to the company. The reality is that eventually, fundamentals will matter. It may take a recession or some other major event to bring investors back to their senses, but it will happen eventually. You don’t want to be the one left holding the stock after everyone else has exited.