Founder & Chief Analyst, Blue Lake Capital Management LLP || IIM Ahmedabad, 2007 || NiSM Certified Research Analyst || Practising Elliottician
“Value investing by its very nature is contrarian.”
– Seth Klarman
The Herd Instinct Psyche
People have a natural tendency to agglutinate. Forming groups and getting lost in the mass. This behavior is not exclusive to humans, animals are social creatures too.
The impetus that drives the herd instinct is a reaction to danger, real or perceived. Our hindbrains assume safety in numbers.
This vestige of our primal minds can either beneﬁt or destroy us.
Financial markets are also not immune to herding behavior. There is enough evidence compiled by behavioral ﬁnance researchers to prove its existence, without a shadow of a doubt.
It goes even further still. Herding behavior – or the tendency of an individual to mimic the attitudes, thoughts, and behaviors of the larger group – can make markets predictable. At least for the wiser investors.
It is also that same behavioral pattern that makes markets risky.
People’s herding instincts can easily drive markets to excesses.
Do you recall the Gamestop meme stock mania of early 2021? In grossly oversimpliﬁed terms, the members of a Reddit group, “Wallstreet Bets”, collectively drove the price of Gamestop stock (a video games retailer) way beyond its intrinsic value and eﬀectively forced a short squeeze on multiple hedge funds that were shorting the stock.
Many lost millions in these events, and many others made fortunes.
Now the odds for a struggling company like Gamestop to reach such a ridiculous stock price in such a short span of time are slim to none if it weren’t for the collective behavior of these Redditors.
Fear Of Missing Out (FOMO)
Herding behavior can be artiﬁcial or organic depending on the situation. Many argue that the high valuations of tech stocks, be it the NASDAQ’s darlings like NVIDIA Corporation (NASDAQ:NVDA) or the domestic blue-eyed boys such as Nazara Technologies Ltd (NS:NAZA) are divorced from the real value of these companies. Instead, they postulate that their prices are driven by hype and the ensuing collective buying of these stocks by eager investors afraid to miss out on a perceived “golden” opportunity. Some market observers feel that stocks, like Adani Green Energy (NS:ADNA), had benefitted too much from the ongoing dazzle surrounding the renewable energy story. Gullible investors in pursuit of “the next big thing” drive prices up for such stocks, without caring much about intrinsic valuations.
These driving emotions of the herding instinct are often referred to as FOMO.
In light of these facts, how should a prudent investor behave?
The solution is simple, yet diﬃcult to implement.
One should strive to keep the hive minds at an arm’s length and in some cases, even adopt contrarian positions.
Indeed, ignoring the group or harboring thoughts and behaviors that run contrary to the established status quo is extremely diﬃcult, even risky.
Think about Zomato Ltd (NS:ZOMT) absurd IPO valuation from 2021 (roughly $9 billion), without having generated a penny of profit. The aftermath for the uninitiated investor was devastating. The stock markets are populated with overvalued companies, holding up their inflated share prices through often ephemerous promises. This sometimes makes the market ripe for short selling or contrarian bets that go against the hype. Short-sellers as contrarians assume that the collective will eventually wake up to realize their foolishness.
Or consider the last global ﬁnancial crisis of 2008, in hindsight. If you recall, the entire US ﬁnancial strata were trading subprime Mortgage Backed Securities (MBS). Only a few lone wolves and contrarian thinkers were able to notice the systemic fragilities of the housing market and bet on its inevitable collapse. It took independent thinking and nerves of steel to go against the grain and take contrarian bets. It wasn’t easy.
Ryan Gosling’s character (holding a $47 million bonus cheque) in the famous movie “The Big Short” (2015), sums it up nicely:
“I took a rash of sh** for two years, but I was right… and everyone was wrong… and yeah, I got a bonus cheque for it… sue me.”
Contrarian thinking is not a given. Those who are able to resist the momentum of the herd are not always met with acceptance.
That said, being right is vindictive in and of itself.
“Being right” is a skill that is not always apparent though. An asset manager who is able to make the right bets and stay the course of his decisions regardless of the backlash from consensus thinkers truly deserves his premium. Though such people are in short supply.
Mediocre managers would rather “play it safe” and buy up the stocks that “everybody” else is buying. And when the stock bubbles up under such pretentious demand and eventually pops, they would have a convenient excuse at hand “well, everybody else too bought into that stock”.
You don’t want to fall for that trap.
Investing legend Bill Miller attributes much of his success to the study of philosophy.
Being smart extends beyond IQ points or solving diﬀerential equations.
Be a prudent investor: This requires a quality that the herd lacks in general, that of “sound judgment”. Sound judgment is cultivated over a lifetime and requires critical thinking. Critical thinking requires a healthy dose of intellectual courage (and honesty) as well as the requisite space, away from the crowd, to exercise quality thinking.
In short, steer away from the crowd and think for yourself.
Do your Research: A healthy dose of Research is imperative to pick the right investments and to avoid falling into the clutches of the Herd-led carnage.
Don’t haste, stay focused: Learn to embrace JOMO (Joy Of Missing Out). Time and again, I come across investors who suspect their decision, moments after pressing the “Buy” button. You’re better off letting go at times than spending a lifetime recovering losses.
Sharpen your contrarian-thinking skills: Side-step the crowd and reason out, before you pull the trigger. More often than not, moving away from the herd will keep you off the pains of losing your capital.
Ask the expert: If the above is not your forte, then it’s wise to consult a Financial Advisor, who is trained to take the right investing decisions and guide you along your journey of wealth creation and financial freedom.
At its root, smart investing is built on the ability to “think right”.
“I am like the Salmon – I have to go against the current – I have to.”
– Knut Hamsun
– The Big Short (2015) directed by Adam Mckay