Investors, beware the herd

If you’ve ever seen it, it’s one of those things you’ll never forget – the mass migration of hundreds of thousands of wildebeest moving across the plains of Africa in search of a fresh feeding area. It’s magnificent to watch. Of course, we know why animals herd together – it’s because there’s safety in numbers. If a wildebeest wanders off by itself, it is more likely to be taken by a predator. But, when traveling with thousands of its compadres, there’s less of a chance that will happen.  But, what works well for the wildebeest doesn’t necessarily work well for humans. True, there still may be safety in numbers, but have you ever seen a herd stampeded off a cliff? Unfortunately, that what happens to investors when they join the herd.

Humans naturally want to belong to a community – a group of people with shared cultured and socio-economic norms. But, in doing so, we still prize our individuality and sense of responsibility for our own welfare. Why is it that, in investing, humans are induced into following the herd – whether it is at the top of a market rally or over the cliff in a market crash? The answer may lie in the natural human tendency to fear being left alone; or perhaps the fear of missing out; or it could just come down to the raw, but very powerful, emotions of fear, greed and envy that drive people to irrational states of mind. 

Human Herds and Market Bubbles

All one has to do to find credence in this theory is study the dozens of “bubbles” that have popped over the last several centuries, all enriching a lucky few investors while impoverishing the rest. We all know of the Dot Com bubble (1999) and the Housing bubble (2006) which are quintessential examples of the herd stampeding over a cliff. Before them, the most famous bubble was arguably “Tulipmania”.  This occurred in Holland (1637) when a mere flower brought down one of the strongest economies in the world at the time. 

Tulips were rare in Holland, so, when a botanist brought tulip bulbs back from Constantinople to be used as a health remedy, his neighbors began stealing the bulbs to sell them.  Soon the wealth began to collect tulip bulbs as a luxury good, and as their demand increased, the price of bulbs shot up with rare varieties commanding astronomical prices.  To put it in context, the rarest of bulbs were purchased for the equivalent of $2,500 in today’s U.S. dollars (2013) which could have housed and fed a family for a year at that time. (Source: “Devil Take the Hindmost - A History of Financial Speculation”, Edward Chancellor, 2000)

Bulb investors were willing to part with just about anything, including acreage in order to get in on the craze. In just one exchange for a single tulip bulb a trader received fine furniture, clothes, a small oxen herd, two tons of butter, and a huge store of cheese among other goods.  At its peak, Tulipmania had whipped up so much of frenzy that fortunes were literally made overnight.  The creation of a futures exchange, where tulips were bought and sold through contracts with no actual delivery, fueled the speculative pricing.  It wasn’t uncommon for an established dealer to generate the equivalent of $60,000 (USD 2011) a month. 

The bubble burst when a seller had arranged a big purchase with a buyer, but the buyer failed to show. Unfortunately, the realization set in that price increases were unsustainable. This created a panic which spiraled throughout Europe driving the worth of any tulip bulb down to a tiny fraction of its recent prices.  Those who did manage to get out before the crash were ostracized by their neighbors who lost everything, and those who defaulted on their contracts were held up to public scorn. In what may have been the first government intervention of a “bubble crisis”, the Dutch authorities stepped in to calm the panic by allowing contract holders to be freed from their contracts for 10% of the contract value. In the end, fortunes were lost by noblemen and commoners alike. 

We may shake our heads in astonished wonderment at what can only be described today as foolishness, but the pattern of Tulipmania has repeated itself many times.  All of these bubbles arose from a herd mentality that started as a “buzz” and quickly escalated into a race to the top as asset prices spiked. In each case, investors were drawn into price movements without regard to the asset’s intrinsic value. And, as the paper net worth of friends, neighbors and colleagues continued to grow, greed ultimately overcame fear (and good sense).  Investors leveraged up in order to capitalize on a “once in a lifetime” opportunity.  And, along the way, dealers, salespeople, stockbrokers and mortgage brokers drove the frenzy without concern for the inherent risk of the investments.  Such are the lessons of bubbles past and present, and while the world has most definitely changed in the five centuries of bubbles, it seem as though human nature hasn’t.

Stay Away from the Herd

Herd behavior may seem natural, even rational for humans. But, generally speaking and in regards to investments, it has the potential to be disastrous for the herd.  While we are all meant to be a part of a community, being a part of a herd can actually hold us back, or, as in the case of the “bubble” drive us over a cliff.  Herds are slow to respond in crisis, but when they do it’s often in the form of a panic. 

It’s natural to feel isolated and vulnerable when you see the masses moving off into different direction leaving you to your own doubts about the validity of your direction.  Would you feel any different if you knew they were heading towards a cliff in the dark of night?  While that is not necessarily a certainty, it can be said that an over-dependence on the hyperbolic media, the latest trends and market performance can lull investors into a blinding complacency that will impede their ability to change direction before they reach the edge.  A measure of protection can be secured through careful planning, a disciplined and value-oriented approach, a knowledge of history and a healthy dose of skepticism.