Last update: 17.09.2024 08:36
Why were we all so wrong? The financial crisis, Brexit, the collapse of a company. A low, a high, whatever. The buzzword is the “we”. Because “I” was critical, skeptical, cautious… But “we” were all sooo sure. Why do we happily rush into investments when everyone else is doing it? And why do we let fear infect us when there’s “thunder and lightning”? The herd effect in investing.
The share price is a price. It results from the supply of shares and demand for shares. The price reflects the assessment of all investors about the value of a company in one price (the share price) on the basis of all information available today. The price therefore contains all known and expected developments. Scientists call this pricing mechanism the efficient market hypothesis. Eugen Fama even received a Nobel Prize for it. So far so good.
How does the demand arise?
On the one hand, there are the historical values. If a share or an index has performed well in the past, we also trust it in the future. And then there are the forecasts. If shares or indices follow a trend, we look to the future with confidence. Although every sales prospectus for financial investments states more than clearly that “Past performance is not a reliable indicator of future performance“. But after all, there is also the behavior of other investors. And they can’t be wrong. Can’t they?
The herd effect in investing
Here’s a little history. After the US lifted the embargo on Cuba, the share with the melodious name “Havana Holding SA” soared. Of course, right? That encouraged some investors to join in. It’s just a shame that the Although the share is named after the capital of Cuba, it otherwise has very little to do with the country. This is because the company behind it comes from Buenos Aires, Argentina, where it operates coffee shops. And, of course, the share price has since recovered. Too bad for the herd animals.
The herd effect in investing describes the phenomenon that we follow the crowd with our decisions. Almost blindly. Even into the abyss. Because all the others can’t be wrong. At least no more wrong than me. And what’s more, I don’t have to think about it myself. That’s convenient. And I can also point to the others when I’m wrong. After all, we were all wrong. That’s comforting. Maybe at least a little. André Kostolany, a well-known stock market and financial expert, once said: “The stock market only reacts to facts ten percent of the time. Everything else is psychology.”
But shared suffering is not just shared suffering. It can also be multiplied by wrong financial decisions or omissions. And there is a simple rule of thumb for this: the faster the masses run, the more uncontrollably the individual runs. In other words: “everyone” can also be wrong. If everyone buys a certain asset class, it becomes more expensive. This is logical, simply because demand increases. Not because the fundamental facts change. This applies to real estate. For infrastructure. Or for gold. Or cryptos.
Summary
Most people feel comfortable when they belong to a group. In the capital market, too, people follow the decisions of other people – they behave like the other members of a group. They buy what others buy, they buy more the more the stock markets rise. They sell what others are selling and sell when the stock markets fall. The herd effect in investing describes exactly this behavior. A piece of stock market wisdom from Baron Rothschild summarizes this succinctly: “Buy when the cannons are thundering, sell when the violins are playing” and builds an entire investment strategy on this. You don’t have to become an expert in anti-cyclical investing. But w e think: When making financial decisions, have the courage to to be critical, especially when others are not. Because it’s your money, not someone else’s.
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