Friday, February 27, 2015

Psychology of Markets - Herd Mentality

Herd mentality is a behavioral phenomenon that was around long before stock markets arrived.  Since the dawn of man, we have been influenced by our peers to adopt certain behaviors, partake in trends and rather simply, just try to fit in.

The theme is no different when it’s applied to investing.  Most participants in the market enjoy the comfort of others when making investment decisions.  They see other investors enter into a market, a sector, a stock, etc and that relieves whatever reservations they may have held and emboldens them to join the fray.  One of the more common causes of herd behavior is that investors tend to follow performance.  So you’ll see a stock or an asset class go on a powerful run only to have the masses plow in once the secret is out and willing buyers are no where to be found.  

This sequence repeats and reveals itself in all facets of life including investing and will do so until the end of time which for a moment we feared was happening yesterday as llamas were running free on our streets and people thought a blue and black dress was actually white and gold.  Alas, we woke up this morning having lived to tweet about it.

It's the sequence described above that has given way to some of the biggest speculative bubbles in history.   From the Dutch tulip craze in the 1600s, to the dot com bubble and the 2007-2008 real estate bust, all were fueled by the spectacular greed of herd mentality.  While a few were granted incredible riches during these manias, many more suffered severe financial impairment.  And often times it was caused by no other reason than just wanting a piece of what everyone else was doing.  Your neighbor was flipping houses, your brother was day trading, your great-great-great-great-great grandfather was convinced that tulip bulbs held all the world’s secrets.  The fallout from these boom and bust cycles have given way to some of investing's most well known lessons and quotes:

“Be fearful when others are greedy and greedy when others are fearful.” – Buffett

"The stock market is filled with individuals who know the price of everything, but the value of nothing." – Phillip Fisher

Josh Brown had a recent post on the topic of scarcity.  Not just scarcity in the markets but life in general.  The post really resonates on a number of levels.  On the topic of herds, he references two companies making a ton of headlines and money right now, Uber and Shake Shack:

“The stock market won’t go down because too many people need it to. It’s not rocket science.

Uber is worth $40 billion. Not the business, mind you, the private-market shares. The business is probably worth a lot, but not $40 billion. But the shares are because they are scarce. You can’t be a venture capitalist and not own them, or have access to them. What kind of a piker VC misses out on Uber? It’s like being at a monster truck rally and not having that t-shirt where the Ford pisses on the Chevy. You may as well go home. That’s why they’ll pay any amount.

Goldman Sachs struck a deal to get access to pre-IPO Uber shares for their wealth management clients. Those clients will never bring up performance, management fees or commissions ever again. The scarce resource covers a lot of ground and works magic wherever it goes.

Same with Shake Shack’s newly minted shares. There’s only one Shake Shack; if you manage a growth fund and miss out on what could be “the next Chipotle”, you’re fired. So you just pay for it. Seven times enterprise value to sales? YOLO. Eight firms on Wall Street initiated coverage of SHAK yesterday. All but one has it as a “neutral” or a “market perform” rating. Every single analyst said the same thing – I’m paraphrasing here – “God, we wish this thing would come down ten points.” That’s how you know it probably won’t, and they’ll be upgrading it later, higher. There’s only one…”

One of the themes within Josh’s comments echo the quote from Phillip Fisher above.  While the folks at the big VC firms and investment banks may see long term opportunity in companies like Uber and Shake Shack, that’s not necessarily the driving force behind their decision to buy a piece of the action RIGHT NOW.  They are buying because of the massive influence of their herd (their peers and clients).  Most do not want to be the contrarian in this trade.  It’s simply easier to follow the masses, play hot potato and just hope you’re not the one holding the stock when the music stops.

BABA would be another recent example of this behavior.  Its IPO last fall was touted for months.  CNBC covered it like a presidential inauguration and we saw people clamoring to get into BABA at any cost.  And for a time that was fine.  The stock IPO’d and rose powerfully.  Now we’ve seen the shine wear off and it’s fallen 30% over the last 3 months. 

We’re not looking to take any long term stance on the direction of BABA’s stock price but there's no doubt that initial post-IPO surge was in no small way influenced by herd behavior.

As you fine tune your process, make sure that you’ve uncovered ways to filter news and outside influences.  It’s always important to hear differing thought and opinion but make sure it’s done so in a manner than does not unhinge your clear headed thinking.  Respect the moves of the herd but don't follow it blindly.

Ryan Worch is the Managing Director of Worch Capital LLC. Worch Capital LLC is the general partner of a long/short equity strategy that operates with a directional bias and while emphasizing capital preservation at all times.

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