Don’t fall in with the sharemarket crowd

The desire to fit in has been part of our nature for thousands of years, but you have to fight against it in the stockmarket.

In the 1950s, Solomon Asch set the world of psychology alight with a series of experiments on ‘social conformity’. In the experiments, subjects were put in a classroom with a number of others (who were all plants) and asked to pass judgment on the relative lengths of lines displayed before them. The plants were directed to give incorrect answers on 12 out of a total of 18 tests and, overall, subjects assented to the incorrect consensus 37% of the time compared to the 1% that was recorded with no peer pressure.

Urge to fit in

Of course, the urge to fit in with the crowd is nothing new: in the context of human evolution, going along with the consensus has generally been a smart move. For one thing, the majority opinion – in terms of things like where the food is and when the tigers are likely to return – has a good chance of being right. And, for another, wandering around in the caveman world alone probably wouldn’t leave you with much time to congratulate yourself on being right.

The stockmarket is no exception. However, as a market, it exists simply as a means of bringing together buyers and sellers for the purpose of negotiating the transfer of securities. As a result, any crowd-like behaviour – whereby people are seduced into trading shares for reasons other than their underlying value – will lead to mispricings; mispricings will lead to someone losing out; and, because they’re the ones paying over the odds or selling for too little, it’ll ultimately be the crowd followers that do the losing.

Standing alone

So being prepared to stand alone in the stockmarket is definitely a good thing. But the reason it’s such a good thing is precisely because it’s such a hard thing to do and most people fail.

How then do we make sure we’re thinking independently? Well, the first step is to recognise that you probably aren’t. All the time we’re subjected to a barrage of analysis, opinion and worthless verbiage on the stockmarket, and when it gets up a head of steam in any particular direction it’s incredibly difficult to remain objective.

When this is combined with feelings of greed brought on by the stack of money you’ve recently made on a stock, or by feelings of fear because of the money you’ve lost, it can become nigh-on impossible. After all, none of us has all the answers on any stock, so it’s easy to imagine that we might be missing something.

Typically it’ll all start very innocently. A company, Flatters-2-Deceive Ltd, will produce a series of good results and its stock will rise – for the very good reason that its underlying value has increased. But, after a while, the price rise itself becomes the news and a ‘feedback loop’ sets in. It becomes accepted wisdom that Flatters-2-Deceive is ‘a quality company’. And when there’s the choice between saying something positive or negative about the stock, brokers and journalists tend towards the former because, after all, it’s a quality stock and they don’t want to look stupid.

Blocking out the noise

So after recognising that there might be a problem with following the crowd, the next step is to try to block out its noise. Successful investors tend to take some trouble to do this. Warren Buffett is happy in Omaha, for example, and Platinum Asset Management’s (ASX:PTM) Kerr Neilson has given it as a reason for basing an international funds management business in Sydney.

The ‘feedback loop’ can work negatively as well as positively. Take assisted reproduction companies Virtus Health (ASX:VRT) and Monash IVF (ASX:MVF), for example. Slowing growth in IVF cycles along with concern over low-cost competition from new entrant Primary Health Care (ASX:PRY) led to share price falls.

We felt the market had overreacted and driven their prices down too low, so we upgraded both stocks in Virtus and Monash IVF claim to deliver on 8 Sep 2014. We maintained our Buy recommendations while their prices continued to fall after Virtus subsequently announced it was losing market share to Primary Health Care (see Virtus warns on growth and Doubling down on Virtus and Monash IVF).

Roll forward to today, and cycle growth has recommenced while low-cost competition from Primary Health Care has had little effect on the premium service clinics run by Virtus and Monash.

Find some allies

Another interesting point about the Asch experiments is that subjects conformed much less frequently to the incorrect consensus if they had an ‘ally’ (a plant that had been instructed to give correct answers). So, on top of recognising the problem and trying to block out the noise, the third plank in your isolationist strategy should be to surround yourself with people you can rely on to give an independent opinion.

Discuss stocks with independent-minded friends and associates. Hopefully Intelligent Investor can also serve as a strong ally.

Finally, and after giving it such a hard time, let’s all give a cheer for crowd behaviour. As one of the stockmarket’s major inefficiencies, it’s why there are bargains to be had in the first place. But if you’re to take advantage of them – rather than be taken advantage of by others – then you need to see the crowd coming and stand clear as it rumbles towards the cliff.

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