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.
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.
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?