Psychology and Investing: Herding

Stock Ideas

There are thousands and thousands of stocks out there.  Investors cannot know them all.

In fact, it is a major endeavor to really know even a few of them.

But people are bombarded with stock ideas from brokers, television, magazines, Web sites, and other places.





Herding Behaviour

Inevitably, some decide that the latest idea they have heard is better idea than a stock they own (preferably one that is up, at lead), and they make a trade.

In many cases the stock has come to the public's attention

• because of its strong previous performance, 
• not because of an improvement in the underlying business.

Following a stock tip, under the assumption that others have more information, is a form of herding behaviour.





Temporary Comfort from investing with the Crowd or a Market Guru

This is not to say that investors should necessarily hold whatever investments they currently own.

Some stocks should be sold, whether because

• the underlying businesses have declined or 
• their stock prices simply exceed their intrinsic value.

But it is clear that many individual (and institutional) investors hurt themselves by making too many buy and sell decisions for too many fallacious reasons.  

We can all be much better investors when we learn to select stocks carefully and for the right reasons, and then actively block out the noise.

Any temporary comfort derived from investing with the crowd or following a market guru can lead to fading performance or inappropriate investments for your particular goals.

Herd instinct - This is probably the most important concept that you need to know about market psychology.

You do not need a degree in psychology to understand that in the short run, the price of a stock can deviate substantially from its basic value because market participants may betray a herd instinct in their behaviour.  This is probably the most important concept that you need to know about market psychology.  

• When people do not understand a company well, they follow the crowd:  
• They chase the winners and dump the losers indiscriminately.

Because of this herd mentality, individual stocks - and the entire market - may go up or down dramatically.  Herding stems from greed or fear.  

When interest rates rise or when there are fears that an important country's economy will falter, world markets react substantially.  It is extremely difficult to time the market or to forecast events that make markets move dramatically.  The lesson to learn is that when the market does go down significantly, prime buying opportunities may surface.

Do you know whether you have the herding instinct?  It's a good idea to find that out if you can.

• The most common phenomenon I have observed is that people feel like buying a stock when its price has recently gone up or when the market has gone up.  If you do so without evaluating the company, you are probably herding.  
• Do you evaluate the price increase in a logical manner?  You are probably not herding if you compute a stock's intrinsic value before you make a buy or sell decision.

Related:

Comparative Qualitative Analysis of Glove Companies

Look at these charts.  At the beginning of 2010, all the prices of these glove companies climbed exponentially reaching their peaks.  These were evidence of herd instinct driven by greed.   Recently, the sector was downgraded and the great, good and gruesome glove stocks were sold down driven by fear.  This was yet evidence of herd instinct.  When people do not understand a company well, they follow the crowd, chasing the winners and dumping the losers indiscriminately.