How Investors Can Outsmart The Herd
Since the market bottom in March of 2009 following the Financial Crisis, the S&P 500 has enjoyed a rise of nearly 300%, a move on par with some of the largest in history. From a fundamental perspective, there has been plenty to get excited about over the intervening years with respect to economic growth, job creation, corporate profitability, and market liquidity.
These factors have clearly been major drivers in the growth of the U.S. stock market over the past several years. However, since the election of Donald Trump as President in November of 2016, it seems that the value of the S&P 500 has come unmoored from its fundamental footings.
In the past 13 months, the primary U.S. stock index has increased in value by more than 25%, while GDP growth has trudged along at a 2-3% annual rate during that time. While tax reform, trade negotiations, and other policy moves have been credited for the market move, we believe that there may be other contributing factors, namely herd behavior.
Herd behavior is the tendency for individuals to mimic the actions of a larger group, even if, individually, most people would make a different decision. Herd behavior is generally regarded as one of the primary causes of society’s most spectacular – and often spectacularly damaging – bubbles.
A number of historical examples exist, including the infamous Dutch tulip mania of the 1630s, when the price of a single tulip bulb reached the equivalent of 10 times the annual income of a skilled craftsman! More recent examples are also easy to find, such as the 34,590% gain enjoyed by the cryptocurrency Ripple in 2017.
It would be difficult to argue that these are examples of rational behavior. So why do humans repeatedly behave in such a way? Research has suggested two possible explanations, both with strong analogues in the animal kingdom.
One reason that animals join herds is to benefit from information that other members of the herd may have, such as knowledge of food and water resources. Humans behave similarly. We assume that a group of investors who have started to pursue a certain strategy must know something that we do not, and we therefore join the group in order to benefit from that knowledge.
The theory is that there simply is no way that so many people can be wrong – or so the thinking goes. But because humans often value resources according to what they think others will pay for those same resources in the future, the lifespan for any popular strategy is inherently limited.
Another reason that animals join herds is to protect themselves from predators. By being a part of a herd, an animal increases the odds of a predator choosing another member of the herd as its prey. By essentially hiding in the herd, an animal can decrease its risk.
Investors do effectively the same thing. They hide in the herd in order to avoid the risk of being alone. Professional investors who pursue contrarian strategies that go against conventional thinking (i.e., the herd) face reputational risk if they are wrong, while being wrong with the rest of the herd can be easily excused.
However, most great investors became so by thinking independently and pursuing strategies that actually benefited from the fact that herds are often wrong – just think of the billions that John Paulson made shorting subprime debt during the Financial Crisis. True investment opportunity often lies in eschewing the herd and taking a contrarian stance that is based on thorough and competent analysis.
It is with that in mind that we strongly encourage investors to ask themselves why a seemingly attractive investment or investment strategy actually makes sense. If the best answer is that it’s popular and everyone else is doing it, then maybe it isn’t such an attractive idea after all. Successful investors think objectively, apply skepticism, and look for opportunities to actually benefit from the fact that herds are often wrong.
The views are those of Matthew Blume as of the date of publication and are subject to change and to the disclaimers of Pekin Hardy Strauss Wealth Management.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.