Investments

Herd investing - explained

Lee Moran

The herd instinct is a trait that has been part of human development for a long time. When everyone was running in one direction, it was usually a good idea to run in that direction too – without waiting to see if there was a bear at the back or a free lunch at the front.

 

Today, the herd mentality is often at play in financial markets. One fund manager decides it’s a great idea to invest in ‘clean tech’ in Australia. He passes on the tip to his fund-manager friends. They buy Australian clean-tech stocks for their clients, and soon every informed investor is in, share prices are moving up sharply, and every investment column and blog is recommending Australian clean tech. More and more people move into the sector, and, by the rules of supply and demand, share prices soar because there’s much more demand to buy than to sell.

Herds cause bubbles

What’s lost in the clamour to get into the next hot thing is the original fund manager’s sound reasons for investing in clean tech in the first place. He had probably decided to buy into the sector for a specific reason – maybe he was investing in a particularly promising renewable power provider – and when he felt that the shares were fully valued, he sold his holding and moved on.

Meanwhile, much further along the chain, people are still piling into clean tech for no reason other than they’ve heard it’s hot. They’ve not done any research; they’ve not set a target buying or selling price. They’ve not noticed that price-to-earnings ratios have changed dramatically. They have no grasp of the fundamentals. This causes an investment bubble and for those who don’t get out in time, when the bubble bursts fortunes can be lost as share prices plummet.

One typical example of this was the dotcom bubble. There were very good reasons to invest in certain dotcom companies in the early 1990s. Most people who didn’t know what those reasons were, but piled in anyway, made a great deal of money as the markets rose and overheated in the late 1990s. But those who didn’t get out in time lost fortunes when the bubble burst.

Will the bubble burst again?

The price of Bitcoin has been causing a stir in recent months with many people suggesting we’ve seen another investment bubble. On 28 November 2017, the price of Bitcoin reached just below $10,000. It had taken Bitcoin eight years to reach this milestone. In just one week, the price jumped to $12,000. 23 hours later it was worth $14,000, and just 15 hours after this it was worth $16,000.

Despite many financial experts warning people not to invest in Bitcoin, such as Bert Dohmen who said that he wouldn’t invest in Bitcoin “even with my worst enemy’s money”, the attraction of rising prices seemed to have proved too much.

Herds miss the good opportunities

Bitcoin has reached several peak prices since November of just under $20,000 in mid-December and $17,000 in early January. Today the price of Bitcoin sits around $8,000.

Several experts claim that the Bitcoin bubble has already burst; others say it’s only a matter of time. Whether the Bitcoin bubble has burst or not, it seems there’s been a retreat by investors, with the volume bought seemingly much lower than it was over the winter months.

After piling into an investment which has crashed, burned and lost money, it’s typical for investors to retreat, lick their wounds, and become over-wary. After the 2008 financial crisis, most ordinary investors wanted safety and security. The property bubble had burst, equity markets had tanked, and investor confidence was at an all-time low. So the herd moved into bond funds, while equity returns soared by more than 50% over the next two years on relatively low trading volumes.

Every investor knows they shouldn’t buy at the top and sell at the bottom, but it’s inevitably what herd investors do. They steam in when the going is good. And then, when the market falls, they lose confidence and crash out.

Run in the other direction

So does this mean you should work out where the herd is going and head in the other direction to become a ‘contrarian’ investor? This would mirror Warren Buffet’s advice to “be fearful when others are greedy and greedy when others are fearful”.

But this is not as easy as it sounds. It’s a difficult strategy that takes a lot of time, research and discipline. Often you end up buying shares when they’re at an all-time low in the hope that they’ll recover. When markets are volatile, it’s very hard to safely say what the perfect contrarian investment would be.

Finding your path

If running with the herd is risky and running away from the herd difficult to judge, what is the best way to invest long-term? The answer is to honestly assess your circumstances, attitude to risk and time frame, and then draw up an investment strategy that will meet those.

Then the ‘trick’ is to stick to your strategy, no matter where the herd is stampeding this week, and regularly review and rebalance your investments to make sure you’re on track. A good financial planner can help you set up and manage your investment strategy to avoid joining the herd chasing the next doomed financial fad.

If you have any questions about anything you’ve read in this blog you can comment below or join the conversation on Twitter, Facebook or LinkedIn. Your financial planner would also be happy to discuss 1825’s investment strategy if you have any specific questions.

If you have yet to find a financial planner and are interested about how an 1825 planner could help you, please get in touch.

 

The information in this blog should not be regarded as financial advice. Past performance is not a guarantee of future return. As with any investment, the value can go down as well as up and you may get back less than you paid in.