Mitigating the Impact of the Herd Mentality on Investment Returns
All winning individuals, teams and organizations have a distinct advantage or an edge. Often what makes them successful is deceptively simple – an easy to understand, thoughtful and replicable process.
Capital markets can be turbulent, chaotic, disordered, unsettled and incredibly complex. Navigating them is not for the uninitiated. Empirical studies show the average individual investor underperforms in the market materially. DALBAR, Inc., a well regarded independent market research organization, has shown through their studies that the S&P500 delivered compounded annual returns of 8.2% from 1996 to 2015. Over the same period, it is estimated that the average individual investor earned a compounded annual return of 2.1%, which failed to beat treasury bills, or keep up with inflation during that same period. The chasm in returns is explained primarily by three factors:
1. lack of a thoughtful, cogent, long-term investment plan; 2. the inherent complexities involved in analyzing investment opportunities and the capital markets; and 3. decision making driven by emotions.
A long-term investment plan serves many purposes: • to set out a vision for where you are, where you would like to go and how to get there; • to anchor decision making and guide investing activities, especially during turbulent times; and • to reduce the chance for emotions to hijack logic and reason.
Most of us are wired to be short-term thinkers. Our natural inclinations – such as fear and greed – tend to take over during times of stress. A common mistake is to sell in response to a sudden or dramatic downturn, or to buy in response to a sudden or dramatic rise in prices. Becoming part of “the herd”is rarely profitable when investing. One only need look at the crypto asset price fluctuations over the past several months to see both fear and greed driving the price levels both upward and then downward at breakneck speeds. As noted investor Warren Buffett has remarked,“Be fearful when others are greedy. Be greedy when others are fearful.”
If an investor commits capital to overvalued assets this will invariably result in sub-optimal long-term returns. This is a common mistake as assets that have performed well attract more capital, thus driving their price higher. Conversely if an investor commits capital to undervalued assets, there is a greater chance of higher-than-market returns. Therefore, it is important to overweight asset categories that are attractively priced and underweight, or avoid assets that are expensive. This is, however, easier said than done when the financial press is doing their very best to whip their readers into a frenzy by discussing why the world is ending, touting some new paradigm or suggesting that “It is different this time”; spoiler alert, it never is.
Finally, to avoid being part of the herd, it is important to re-balance the portfolio from time to time. Periodic re-balancing, the act of bringing an investment portfolio back to its desired asset mix by taking profits out of outperforming investments and re-investing those returns in underperforming assets, can be very helpful in avoiding the direction of the crowd. There are many benefits to this guideline:
• it can enforce a level of discipline in terms of selling a portion of the winners and investing the proceeds into asset classes that have underperformed; • it can help save investors from their own worst instincts; and • it will reduce the overall risk of the portfolio and help to ensure that financial objectives will be met.
The steps discussed above are designed to insert a rigor and discipline into the investing process to keep one focused on the long term and reduce the distraction created by the noise that surrounds us.