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Market Health

Herd Mentality Is Making Investors Go Broke

It’s getting old… fast.

And it’s going to end in tears for hordes of investors.

Every morning, I get texts and messages asking about the “fad stock” of the day.

It started with GameStop (NYSE: GME). Then it spread to AMC Entertainment (NYSE: AMC) and even to the joke cryptocurrency Dogecoin.

But no, the mental illness affecting millions of investors – part greed, part ignorance and part ire – is seemingly spreading uncontrollably.

Koss (Nasdaq: KOSS), Sundial Growers (Nasdaq: SNDL), Naked Brand (Nasdaq: NAKD) and dozens of others have been affected.

It’s the new pandemic that rational investors must face.

These are precisely the types of moments in which we need to reflect on our own investing habits and remind ourselves not to do something dumb, potentially threatening our financial independence.

The Other Universal Constant

Don’t worry… You’re not alone.

We’ve all made investing blunders and missteps.

In my opinion, failure is more important to learning than success.

Failure hurts.

Failure keeps us humble.

Failure teaches us what we shouldn’t do.

Unfortunately, many people are guilty of making the same mistakes over and over again. And in the markets, compounding these mistakes can be costly.

Now, the issue is our brains.

We’re not psychologically wired to make rational decisions with our money.

Instead, we’re actually wired to be foolish, sentimental and illogical. And we are badly flawed.

You don’t need to look further than any “investor” or “trader” claiming GameStop is a $1,000 stock and talking about “diamond hands” for an example of this.

We know those people are probably underwater on their positions.

Behavioral economics is one of my favorite fields to read about. And I think it’s an important one for investors to understand. That’s why a copy of Nobel Prize winner Richard Thaler’s Misbehaving has a prominent spot on my office bookshelf.

We’ve all heard the saying “You talk a big game.” Well, according to behavioral economists, many of us are guilty of this, especially when it comes to finances and investing.

Not only do I have serious doubts about the claims made on social media boards about all the money that certain posters are making, but there is another side to this.

We say a lot but often do very little to nothing.

For example, we say we’re going to do thorough research…

We tell ourselves we’re going to pick fundamentally solid companies…

We’re adamant that we’re going to remain logical about our decision to sell…

And this time, we mean it!

But in reality, we often do no such thing.

Without going into the gory details, study after study shows that nearly all individual investors make irrational stock market decisions.

This is practically a universal constant. Just like the speed of light or an electric charge.

The Madness of Crowds

We’ve dedicated a lot of pixels to the investor cycle of emotions over the years.

This cycle is driven by irrational behaviors such as narrow framing, anchoring, mental accounting, failure to diversify, media response, regret and overly optimistic assumptions.

We’ve even outlined how a hatred of the rich ends up making a lot of investors poor.

That’s become the fuel for the irrational behavior looming largest at the moment: herding.

This is now an everyday occurrence in the market, thanks to the proliferation of social media and “meme” stocks.

Herding is simply investors following each other from one security to another. There is no fundamental reason for the moves. Investors are just blindly doing whatever other investors are doing. This leads to panic-selling and chasing a stock higher.

The hallmarks of herding are irrational rallies and sell-offs with zero fundamentals to support them.

Take GameStop, AMC and, especially, Dogecoin as prime examples.

Now, if you’re at the front of the herd – with no one else’s rump in your face – it’s great! It works in your favor. But the further down the line you are, the more behinds there are blocking your vision, the worse it smells and the worse your performance will be.

Inevitably, herding ends in disaster.

To this day, the dot-com bubble stands as a monument to the damage that herding can cause.

Even so, you’ll undoubtedly hear, “This time it’s different.”

Those are four of the most dangerous words in investing.

And it’s not merely herding. All of these behaviors are hallmarks of the highly ineffective “buy high and sell low” strategy that most investors tend to fall into.

It’s easy to fall victim to them.

And these are the enemy of the average investor.

Write them down on a sticky note… Print them out and pin them to your office wall… Do whatever you need to do to remind yourself to look for these common missteps.

Because, in the end, the herd stampedes off a cliff. And you don’t want to be part of it when it does.

Remember, there are misguided souls who bought shares of GameStop at $400, believing it was going to $1,000… as well as others who bought AMC at $20 and Koss at $127. And they’re probably telling themselves, “It’ll come back!”

They’ve got “diamond hands.” But in reality, they’re just going broke.

Here’s to high returns,

Matthew

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