I have touched on several behavioral finance topics in past articles, and this month I want to continue that by talking about the social side of investing.
When we see a crowd of people running, our instincts tell us to follow whether we know why or not. It is unclear whether we are running toward something or away from it, but we know that following along is a safe bet. While that may be a silly, extreme example, the reality is that the actions of others influence us all the time. The actions we take, things we eat, products we buy are in part a decision made with the idea that it needs to be consistent with how a reasonable person would or should act. This herding behavior is not only a defense mechanism in the animal kingdom, but also a defense mechanism in the social and financial realm as well.
Herd mentality is the tendency to assume that the crowd knows things that you do not. While this tendency may make sense most of the time, it can also lead us to bad outcomes. Panic driven selloffs and market bubbles can be a result of our tendency to herd toward what others are doing.
Some of the more well-known examples of this behavior have happened in our recent past. We have seen meme stocks explode for periods since 2021. NFTs were hot digital items that skyrocketed in value only to plunge back for the most part. The most famous large-scale bubble in recent memory was the dot-com bubble. It was not that everyone was wrong, and the internet was not going to take over modern life. It was that stocks with a “.com” in their name seemed to explode in price despite not having revenue or earnings to support it.
A famous example, pets.com, wasn’t necessarily a bad idea; it was just too early. The concept was ahead of its time, as successful companies like Chewy proved years later. If we search through the graveyard of failed dot-com companies, we will find many companies with similar business models to brands we recognize today. There is a similar feeling of excitement in today’s AI boom. Many companies are stepping into the game whether that is training models, providing infostructure/energy, supplying materials, building chips, or implementing the technology to complete tasks. While there are many startups and smaller companies in the fray, there are also some of the biggest, most profitable companies in the world leading the charge in AI. Many AI companies are not just an idea, they are integrating innovative technology into existing, robust business models. So, while there are some parallels to the dot-com boom, there are also some key differences as well. Like with any big shake up, there will be big winners, big losers, and often changing opinion on who is “winning” the AI race.
Momentum is powerful, especially in financial markets. Ideas can be considered “wrong” for years until proven correct, once momentum shifts. While fighting the herd is not advised in most cases, it is important to try to remain objective, think independently, and look at fundamental factors that drive your long-term plan. The goal is not to fight momentum, but to be aware of what is driving your decisions—and to ensure it is not just social forces or FOMO.
