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How to benefit from herd mistakes

April 12, 2020

reading time: 8 minutes

by Tim Cooper (guest author)

Bull or bear?

Smart investors can take advantage of herd mentality – if they are disciplined.

The Covid-19 outbreak has been a typical example of herd mentality among investors. As the virus spread, panicky investors have sold their stocks, leading prices to plummet far below their fundamental value. Many will lose money in the process because they let emotion rule their decisions.

Behavioral science shows that investors are prone to many such emotional mistakes and biases. Two of the most damaging are fear and greed. These often lead to an irrational herd mentality, buying investments when prices are high and selling when they are low, causing significant underperformance.

More disciplined investors can profit from this herd instinct by using so-called contrarian or trend following strategies. But it requires a careful understanding of markets and crowd psychology as not all herd instincts cause underperformance, and contrarian or trend following strategies do not always work.

Causes of herd instinct

In investment, following the herd means doing what you see other investors are doing, rather than following your own, perhaps more rational, analysis. 

According to investment strategist Manfred Hofer, who is responsible for behavioural finance analysis at LGT Capital Partners, the realization that people seldom act rationally is not new but our understanding of how it affects investments has grown significantly. 'Investors often act irrationally and run after the herd - instead of making nice profits, they often end up with losses,’ he said.

Investors often act irrationally and run after the herd – instead of making nice profits, they often end up with losses

Manfred Hofer, LGT Capital Partners

Hersh Shefrin is professor of finance at Santa Clara University and author of Beyond greed and fear. He said that, since the 1990s, there has been good evidence that herd instinct can drive the tendency of many investors to sell low and buy high.

‘Many psychological experiments have shown how people tend to conform - even when they believe conforming is objectively wrong,’ he said. ‘They do this to avoid rejection by other members of the group. Being part of a herd means protection from error. Making a mistake and feeling alone combine to generate deep pain. Making a mistake when others do likewise blunts the pain.’

But this collective tendency often leads investors to behave irrationally, creating short-term disconnects between share prices and fundamental data on corporate performance. The result is bubbles, such as the 1999 dot com boom, and crashes as seen during the 2008/2009 credit crunch and the current coronavirus outbreak. Bubbles are market rallies based on unfounded confidence and greed among investors. Crashes are caused by panic sell-offs.

Hofer believes that behavioral economics can provide answers to this problem. 'The findings from behavioral finance can help ensure that, metaphorically speaking, not too many investor lemmings jump off the cliff.'

Exploiting herd behavior

Some investors believe they can improve the decision-making process, identify such irrationalities when they happen, spot mispriced securities and take advantage.

For example, they may use a so-called contrarian strategy, which deliberately buys cheap stocks in a falling market, when the herd is fearful; and sells when the herd is greedy and overbuying.

This requires them to apply consistent rules to investment decisions to reduce the role of emotions. For example, you could set a rule to sell a stock or index at a certain price based on its fundamental value, rather than continuing to chase it upwards.

One intrinsic downside for contrarian strategies is that they can cause pain for short periods, particularly when markets are behaving irrationally.

Following momentum

Momentum strategies are another way of turning herd instincts to your favor. Momentum investors recognize that trends can persist for some time, so they develop strategies to capitalize on the continuance of existing trends for as long as possible.

Some momentum investors even believe it is possible to profit by staying with a trend until its conclusion, no matter how long that may be. For example, momentum investors that bought into the US stock market in 2009 generally enjoyed an upward trend for a whole decade.

One momentum strategy involves going ‘long’ on upwardly trending investments, which means betting on their long-term positive performance. Alternatively, they can ‘short’ downward trending assets, which enables them to profit from negative momentum.

Momentum strategies would also use a set of indicators to identify trends, and strict rules to dictate entry and exit points.

The downside of momentum investing is that there is no guarantee of being able to anticipate a swift reversal in a trend when it comes. The rules are based on historical data but history rarely repeats itself exactly. So a momentum strategy relies on history being a good enough guide to make your strategy right more often than not.

Making it work

Shefrin said you must be smart and well-informed to make these strategies work.

‘In Beyond greed and fear, I concluded that most investors are too prone to psychological pitfalls to exploit market mispricing successfully,’ he said. ‘Trying to beat the market this way requires investors to put their egos on the line. In terms of the odds, they are better off being content to earn market returns, for example, by investing in an index tracker on a buy and hold basis. However, a few smart investors will figure out where the mispricing is.’

Shefrin’s colleague Meir Statman, also professor of finance at Santa Clara University, said investors need to beware that herd instinct is not always detrimental to performance.

‘If some restaurants you pass have only two diners, and another is packed, joining the herd is a good idea,’ said Statman. ‘All the diners in the busy restaurant might be as ignorant as you. They might be all tourists, or the owner’s family. But there are probably knowledgeable people among them. So people don’t follow the herd because they are idiots but because there is some information among the herd.

‘The problem occurs when that information contains some bias. For example, in chat rooms investors talk about gains proudly but stay quiet if they have losses. That creates a biased view. But equally those people may have good information - so you need a good reason to believe this is all hype and prices are over-inflating, for example.’

Contrarian investors may think they are smart, but they may also be overconfident, he added. Staying well-informed and following rules help keep you in the former bracket. Manfred Hofer concurs: 'Our many years of behavioral finance experience confirm that we can gain a lot from both countercyclical investing and the momentum approach. However, it depends, among other things, what phase the markets are in. That is why we developed a conclusive overall behavioral finance concept for analyzing markets.'

Behavioral finance at LGT

Behavioral finance analysis has a central role in LGT Capital Partner's investment process, and goes far beyond the individual approaches discussed in this article.

Some basic principles include:

  • uncertainty leads to diversity of opinions
  • communication influences opinions directly
  • a trend is a step-by-step acceptance of a new vision
  • synchronization of opinions leads to mispricing
  • mispricing leads to trend reversals

These principles lead to the following rules:

  • buy a trend as long as it is controversial
  • sell a trend as soon as it becomes mainstream.

For more information, please also visit our pages on our investment expertise

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