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Thursday, April 2, 2015

Psychology in Crisis and Herd Investing

The market has been consolidating right at the top for a few months now and it seems very difficult to predict where it's going to go next as it had always been. Having said that, there will always be incoming new investors on board who are intrigued by the seemingly "successful" safety boat in the market by plunging right in without requiring sufficient research on the product itself. After all, everyone makes easy money during the bull market. Well, maybe not everyone but almost everyone.

You may have heard of the story that Joseph Kennedy sold his stocks on the cusp of the Great Crash of 1929 after a shoe shine boy shared trading tips with him. There was strong evidence that the surge in the recent China's equity markets was driven by momentum rather than fundamentals. For instance, China brokerage firms recently reported a triple increase in the amount of new account being signed up during these few weeks leading to a record high of 2.8 million, which is the size of the entire population of Chicago. New trading accounts and trading volumes have soared. Expectations on growth and profits have not. The reason for this is simple -- Herd Investing




Herd Investing

The Herd mentality comes from the social psychology terms that deals with the behavior of human beings in large groups. This mentality allows the tendency of people to think that whatever the behavior of the group is doing must be important and right and hence it makes sense to simply follow them (consciously or unconsciously).

Take a simple case of queueing up in a hawker center. More often than not, passerbies would usually be curious if they see a queue forming up in a particular stall, even if they have not heard of the stall previously. The idea behind the logic is if everyone is spending time to queue, then there must be something special about the food. 

The same logic goes in the stock market. When a newbie comes into a stock forum discussing of a particular stock tips, he would tend to look for common consensuses that pick on the same stock before proceeding to purchase himself. The idea behind the thinking process is if everyone is advocating a buy, then the stock must be an attractive buy at current price.  It is also very comforting to know that everyone is in the same boat as yourself, so when something goes wrong, at least you are not the lonely one out. This crowding move of herd investing usually sends the stock price upwards beyond its valuation before it then crashes down or retreats to the long term average mean.





Exploiting Herd Investing = Crisis Investing

The opposite is usually true as well.

A Contrarian usually sits on the other side of the fence awaiting to exploit the power of herd investing. They called it Crisis Investing. When bad news broke out, people usually look out for the exit much faster and the mentality of herd investing comes into play once again, twice as fast this time. Imagine a scene where you are entering a very famous broadway play where all tickets are sold out on the very first day it was launched due to heavy demand. Some people are smart enough to resell the tickets on the black market to gain instant profits from it and there are still people who will buy them. However, imagine that when a fire suddenly broke out in the middle of the scene, you can imagine how twice as fast they will run for their lives.

Crisis Investing is not as easy as it seems to imply. Many times people would hoard a huge sum of cash or warchest that are meant to be utilized during a crisis situation. But it's all easy when we say in words but difficult in action. One way crisis investing would work well is to continuously preparing for extensive research even during moments when there is nothing to buy. This includes preparing for an extensive research and keeping up with the companies news throughout the period you are putting them on a watch list. Many times, investors failed to do so because when an investor is out of the market, there are no money worth on the table that requires forking out the effort.

Any impactful crisis scenario will irrationally cause some amount of fear in the market and provoke the panic selling button. It can create a situation where selling begets selling which a contrarian can take advantage of during these turbulence of market inefficiencies. At this time, an investor should be on the move when everyone is running for the exit because this is probably where there are most meats on the table. Of course, the investor will need to be sufficiently prepared for any further downside after doing their own due diligence.





Final Thoughts

Successful investing is more often than not counter-intuitive and contrarian in nature.

We don't want to be in a buying position where many people and news are already talking about because it will definitely not present a value to buy as the market has priced in the positive news. This means that no matter how great a business fundamentals are, there will be times when it doesn't look good enough to buy simply because protection downside are missing.

So what should we be hunting? According to behavioral economics and findings from crowd psychology, investors should be looking for the most hated, out of favorable stocks that are suffering from temporary loss of confidence in the business. Do note that the word temporary is important because a permanent change in the fundamentals would warrant an investor to reassess the company's undertaking based on the latest risk adjusted return. Simply finding the most hated stocks out there will also not help if we are not able to correctly justify the underlying reason for why investors are shunning away from the stock.

Being able to insulate our thoughts and emotions from herd investing allows us to think better and deeper and allows us to understand our own investment mistakes over time. If you are right about crisis investing in companies that suffer from a temporary loss of fundamentals, then the higher the likelihood that the company is going to outperform the market through expanding earnings and cash flows that allows you to return much greater than you ever think of.

What do you think of herd investing? Have you ever been subjected from herd investing yourself?


21 comments:

  1. Hi B,

    It is the nature of human beings to herd. The only way to neutralise is via experiences or knowledges. Easier said than done.

    Brain over Heart Maybe!

    Rolf

    ReplyDelete
    Replies
    1. Hi Rolf

      Herd mentality is very comforting knowing that more brain is working than one.

      In fact I dont see anything wrong with herd mentality in any other forms of activities other than stock picking where everyone is picking out for value and thats where its hard to find when it is subject to the herd mentality.

      Delete
  2. Hi B,

    I think we need to focus on the other side of this perspective regarding herd investing. Oftentimes, we hear of pple saying that we shouldn't buy when the stock market is high, because doing that is like following the herd chasing ever higher prices. But I think it's equally impt to talk about not selling when others are selling too - and we don't often hear about this.

    I also think that we cannot be a contrarian for the sake of being one. There's a saying by Buffett that we should be greedy when others are fearful and fearful when others are greedy that is mis-used greatly. If others are selling and we opt for the opposite action of buying, it will be equally as bad as when others are buying and we opt for the opposite action of selling. The reality is that the opposite of selling is not buying. There's other options available, like not doing anything.

    ReplyDelete
    Replies
    1. Hi LP

      I agree wholeheartedly with you that there's often a lacking of arguments from the other side for most of the quotes we often hear from famous investor.

      In fact, I think the selling herd mentality works faster than the buying herd mentality because for buying people sort of think and delay a little while before eventually succumb to buying but for selling it's action first then think.

      The quote of buying when others are selling and selling when there are fear in the market is way over generalized and mis treated. I have seen in forums where people quote this as the sole reason to justify their buying and it seems clueless or pointless to say the truth because there are more fundamentally important reasons they need to think of first.

      Delete
  3. In a bear market, many short sellers will appear mixing with the herd selling. This is opposite of bull market buy high, sell higher. That is sell high, buy lower. Short sell is better.
    Which market you like?

    ReplyDelete
    Replies
    1. Hi temperament

      Herd selling mentality goes faster because people act first then think so it pushes the momentum for short sellers to price the stock even downwards.

      That's why going down is often a rollercoaster more than going up ;)

      Delete
    2. What is actually Herd's instinct?

      Don't we all want to sell everything if we are sure the Market is going down 40 to 50 % (in very near future) has just begun?
      We don't have to be a short seller if we don't know how to be one?
      Are you sure all the front runners of the Herd are all wrong?
      Some of them may be the perpetrators?
      And some of us just follow blindly behind too late.
      i think the front runners will just buy back later.
      Market Timing anyone?

      Delete
  4. Howard Marks talks a lot about second level thinking, basically thinking differently. I believe that if you do what everyone is doing then you can't expect to get a better result. Great post, cheers!

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    Replies
    1. Hi Henry

      I've read a couple of his memos that surrounds thinking on a deeper level from more angles. I think it helps to do that, some may argue to the extent of overthinking. But to find value one needs to be the first one on the queue then let herd mentality takes its best form to price it upwards ;)

      Delete
  5. Replies
    1. Hi jfree

      Harvest and prosperity! !!! ^^

      Delete
  6. B,

    It took me quite a while to figure out the meaning of "this stock is a buy; but not at current prices".

    I once made a poke to "pseudo Value Investors: "Do you sell when your value buy reaches fair value or wait till it gets overvalued?"

    I guess we can invert that question: "Do you wish to buy at overvalued, fair, or distressed prices?

    ReplyDelete
    Replies
    1. Hi SMOL

      I think there's always a lot of doubts over buying and selling and no one can say whether one is right unless we are basing it on hindsight past results.

      For myself, I really think everything has a price to pay for. If all the valuations in my portfolio somewhat doubles right now, I have no qualms but to sell them and spend the gains in a Caribbean beach right now ;)

      Delete
  7. When our favourite "Gu Shen" bloggers bought then it is quite safe to follow after we do a bit of homework ourselves to confirm it.

    Wah! The numbers really looked good. I have been there before. :-)

    But, one day we will learn the hard way. When they sell they won't announce immediately so we can't really follow.

    :-(

    Herd mentality?

    ReplyDelete
    Replies
    1. Hi Uncle CW

      For either buy or sell, action first then blog about them.

      When something goes wrong, dig a hole and hide beneath them ;)

      Delete
  8. Hi B,

    Besides preventing the herd instinct from taking root in us, we should try to profit from others' herd investing.

    Afterall, human weaknesses have not changed for the past 1,000 years and I doubt it will improve much for the next 100 years.

    ReplyDelete
    Replies
    1. Hi 15hww

      I think those contrarian experts are taking advtange of this big time as they know once bad news broke out they will be one to make the big move.

      Delete
  9. Hi B,

    I totally agree that you should not be influenced by others when deciding on what to invest. It's best to do your own homework first!

    I’ve been reading your blog and as someone who is relatively new to trading and investing, I found your materials useful! I just started a blog and I hope you could drop by and check it out!

    It would be nice if we could connect our sites too.

    My blog: http://www.sgtrader92.blogspot.sg

    Regards,
    Sgtrader92

    ReplyDelete
    Replies
    1. Hi SGTrader92

      Many thanks for your support.

      I've linked your blog to the site. Great blog, keep it up. I've left some comments on your post.

      Delete
    2. I've updated my site! It's now www.sgtrader92.com

      Thanks for the support as well B!

      Delete
  10. Hey B, I fell prey to herd investing when I first started finances. At one point, I started buying stocks that other personal finance bloggers online have been buying. Not to say that their purchases aren't fantastic ones, I have found that I will need to do my own research when considering stocks. Currently, I am building up my cash position in preparation for the bear market which I predict to occur in the near future. Very interesting concept of herd and crisis investing. :)

    ReplyDelete

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