Following the masses is a dangerous investment strategy. In the field of behavioral finance, there’s a term for this phenomenon – herd mentality bias.
Herd mentality bias refers to investors’ tendency to follow what other investors are doing. The problem with herd mentality bias is investors’ investing choices are driven by emotion and instinct instead of sound financial analysis.
The problem with the masses is they don’t have a mind of their own. They listen and follow whatever the talking heads are saying on CNBC or what they hear or see on Social Media.
A recent research paper found that social media had an amplifying effect on stock market volatility where a piece of information spread on social media would have a multiplying effect not seen in traditional media – moving the needle of a stock or the market well beyond what would be expected.
Here’s an example of the dangers of following the masses: If you followed the masses and piled into Bitcoin on January 8 of this year at $41,529.29; as of today, you would have lost a quarter of your investment.
If you’re following the masses and plunging into the stock market, you could be in for rough waters. Since the election, the Dow has been on a tear, gaining more than 12.5% in value. But, as the Dow has shown in the past year, what the Dow gives, the Dow can take away.
After hitting a previous record high in February of last year, the Dow plunged more than 35% in the early days of the pandemic in March. It recovered all those losses by August but the gains were not supported by economic fundamentals.
All previous recoveries following crashes of the magnitude seen in March typically took at least four years. After the last big crash that kicked off the Great Recession, it took the stock market four years to recover to pre-Great Recession levels. The Dow is currently trading at twice its historic price/earnings (PE) ratio average. In other words, it’s way overvalued and is headed for a correction.
The masses right now are investing purely on emotion. They think they’re outsmarting the market, but the market has proven time and again that it’s hard to beat. As it has proven time and again, the market will shake off the mob effect and correct itself to match the underlying economic realities.
The reality right now is that unemployment is still high and not expected to get better with Biden’s war on the fossil fuel industry where thousands of jobs have already been lost since the inauguration. GDP remains stagnant. The combination of these factors will eventually catch up with the stock market once reality sets in.
The masses are short-sighted. They only think short-term – making investment moves based on the timing of the markets – hoping to zig before everyone else does to profit from climbing prices.
The problem with short-term stock picking is it doesn’t work. Even the professionals are lousy at beating the market as 92% of mutual funds who take a short-term, active approach to invest fail to beat the market.
What do investors who don’t follow the masses do?
They invest long-term. They go out of their way to shield themselves from the effects of the masses. Long-term investments with long lockup periods prevent investment decisions driven by emotion.
It prevents panic-stricken decisions. It’s like grounding your teenager from the car by taking the key. No better way to prevent a crash than to eliminate the ability to get in the car.
By investing long-term, not only do elite investors avoid the dangers of investing with the masses, but they are also able to leverage a commodity that the masses ignore – time. With patience, the right investments can not only provide income that can be reinvested and compounded but can also grow over time.
A timing-based investment strategy solely focused on profits from buying low and selling high to the next sucker ignores the two essential elements ultra-wealthy investors have long relied on to generate wealth:
- Cash Flow.
Not much has changed since high school where the masses can pressure you into doing things that are stupid, dangerous, or both.
When investing, don’t follow the masses. You could end up doing something foolish, dangerous, or both.