Don’t Follow The Herd: Why The Majority Of Investors Always Get It Wrong

June 26, 2017

Don’t Follow The Herd: Why The Majority Of Investors Always Get It Wrong

  • Consider this, the question always remains the same: “What will my return on investment be?” But the answer changes all the time.
  • Thinking costs energy and humans prefer to let others do the thinking for them. Are you like that?
  • It’s important to know when to use history as a teacher.

Introduction

“Whenever you find yourself on the side of the majority, it is time to pause and reflect.” 

– Mark Twain

When Albert Einstein was teaching at Oxford University, he gave his senior physics students exactly the same exam he had given them the year before. His assistant was disturbed by such a mistake, but before intervening he asked Einstein whether he actually made a mistake. Einstein replied that the exam was exactly the same. The assistant was even more concerned and asked why he would do such a thing. Einstein replied, “Well, the questions are still the same, but the answers have changed.”

I find this a very interesting allegory because if the answers can change in the precise, mathematical world of physics, one can only imagine how much the answers can change in the behavioral world of economics and finance because natural laws determine physics while our behavior determines what happens in the economy and financial markets.

However, the majority of investors just keep doing what they know over and over again. We go through 16 years of schooling where the main premise is that history is the best teacher, and then step into life expecting that if we replicate what others have done in the past, we will achieve the same results or better.

The issue is that we aren’t taught to take into consideration new things and things that could happen but have never happened before. Therefore, the majority just keeps doing what worked in the past and expect the same result. What’s more, when they’re not happy with the result, an individual, institution or country starts to do more or less of the same expecting better results. Just think of central banks and quantitative easing.

Even if it’s clear that the long-term structural problems won’t be solved by putting more money into the system as doing so just postpones the inevitable, in addition to making the next crisis worse, global central banks just keep putting money into the economy.

Politicians are happy with what’s going on and, for example, the focus is not on changing the school system in order to increase productivity or improving legislation to make corporations more globally competitive. On top of it, what’s mostly followed by the media isn’t how smart the population is or how productive, but what Yellen, Draghi or Kuroda have to say.

In 2009, all central banks stepped up and injected the highly necessary cash into their respective economies. However, as the results weren’t satisfying by 2012, central banks injected even more money into the economy.


Figure 1: Total assets – Bank of Japan (blue), FED (red), ECB (green). Source: FRED.

The FED has hiked interest rates a bit and is thinking of slowly lowering its balance sheet, we’ll see how that works out. However, the ECB and BOJ continue to print more money to reach their inflation targets.

The situation isn’t much different in the investment field. Given the success stock market investors have had in the past 8 years, especially those owning index funds and ETFs (exchange traded funds), inflows into these assets have risen to historical highs.


Figure 2: ETF inflows are at historical highs. Source: Bloomberg.

As you can see in the chart above, ETF inflows in Q1 2010 were just $10 billion. Today they are around $132 billion.

Investors buying stocks in 2010 were the minority as stocks were considered risky due to a bear market. Now that stocks are three times more expensive, the majority of investors invest in what has been one of the best investments in the past 8 years and they expect similar results in the next 8 years. Those who bought in 2009 and 2010 have probably already sold their positions. What do you think, who is right?

Scientific research has shown that only 3% of people do things differently while the rest of us just continue to smash into a wall like some crazy energy bunny on steroids. A bunch of energy bunnies on steroids is exactly what the stock market and current central bank activity looks like to me.

This leads us to the question, why is that so? The scientific answer is that we are wired to think as little as possible because it takes a lot of energy to think and we prefer to run on auto pilot.

In financial markets, it takes a lot of energy to think, research, analyze the macro and micro environment, and do deep due diligence on individual stocks. Therefore, it’s better to just do what everybody else is doing with the hope that someone is actually thinking. Additionally, if you don’t do what the majority does in financial markets, you will certainly be wrong for some time because financial markets are a voting machine in the short term and are only a weighing machine in the long term.

Now, short term history shows us that those who do as others are doing do well. However, longer term stock market history shows that the majority are mostly wrong and that it usually costs them a lot of money.

I have pulled the S&P 500 chart from 1960 to 1982 to show how what happened in the recent past doesn’t have to replicate itself in the future.

From 1960 to 1968, the S&P 500 more than doubled and everybody was crazy about stocks, especially the “nifty-fifty stocks,” or large cap blue chip stocks. The enthusiasm was so high that the CAPE ratio (cyclically adjusted price earnings) reached a level of 22, a level that hadn’t been reached since the 1920s. The result was that it took exactly 15 years for the S&P 500 to definitively leave behind its 1968 level.


Figure 3: S&P 500 from 1960 to 1982. Source: Author’s data.

Today we have an 8-year bull market and everybody is crazy about FAANG stocks. The CAPE ratio has surpassed the 1929 level and on top of it, the economy isn’t doing that well at all when compared to historical expansions. Will the majority be wrong again? We’ll see.

Conclusion

So history has shown many times over that what the majority is doing is mostly wrong because the majority doesn’t think, which is a very dangerous thing especially in the stock market.

I see the current situation somehow similar to the situation in the 1960s. However, I was the one who said that history shouldn’t be our teacher. Therefore, as always, the best advice is to think for yourself, know the risks you are willing to take on, and how your financial decisions will affect your quality of life. It all starts there. What the stock market will do in the next year or so should be secondary.