Using the Herd to Your Advantage

KEY TAKEAWAYS

• Contrarian investors say buy low sell high, but the human brain may make this more difficult than you could imagine
• The human brain is poorly designed to process the emotions of fear and greed.
• Savvy investors have learned how to overcome this weakness with a handful of habits and investing principles.
• With financial markets near extremes, investors may benefit by learning how to use the herd to their advantage as a way to manage risk in an investment portfolio.

Buy low. Sell high, is what they say to do when investing.

Sounds like a prudent investment plan, right? Well, when it comes to investing in crypto, stocks or any risk asset that can spark the animal spirits of – fear and greed – acting in alignment with the adage of “Buy low, sell high” may be harder than you think.

Investments related to financial markets are in an endless cycle of ups and downs. At times these ups and downs reach extreme historical norms in both price and emotion leaving an investor with questions like – “Should I buy?” or “Should I sell?”

The problem for most investors is that some of the greatest investment opportunities may be found when the questions of should I buy or should I sell meet extreme levels in emotions and our brains are not well designed for this. History has shown time and time again that average Joe investors have a tendency to buy at the highs and sell at the lows which is the exact opposite of a successful investment plan, why is this?

Investing Fallacies

Fools theory, gambler’s fallacy and the sunk cost fallacy are just a few of many examples that may help us understand how poorly designed the human brain is to avoid cognitive bias that can be detrimental to an investor’s account values.

Our brains have an automatic firing mechanism (specifically, in the basal ganglia system) that generates excitement. Our excitement may not even be recognized at the conscious level, but it leads us to react. And these reactions are governed by the prefrontal cortex, which manages goal-directed behavior.

Similarly, when investors see stock prices increase, their basal ganglia system produces excitement. And who doesn’t want more of a good thing? So, the investor buys more stock, only now he’s paying a higher price and probably increasing his risk.

A similar mechanism exists on the other side of the equation when it comes to fear of loss and falling prices of an investment. Some of the main chemicals that contribute to the “fight or flight” response that is associated with fear as well as losing money are also involved in other positive emotional states, such as happiness and excitement.

By understanding how our emotions influence our investing decisions, we can create policies and procedures to mitigate their influence, which will enable us to make successful investments.

One of the perks that has come from working with savvy, well-seasoned investors over the years has been gaining valuable insights from the habits that they instilled within their investment strategies to override this weakness of the brain to build lasting wealth. With financial markets near historical extremes, we thought it would be a good time to review one of the more important lessons about contrarian investing that we have learned from some of the greatest investors of modern times.

Use The Herd To Your Advantage

There is a famous quote from Warren Buffett about investing that says “It is best to be fearful when others are greedy and greedy when others are fearful”.

The “others” in Warren’s mind, are what we term “The Herd”.

Invest long enough and you’ll find that markets will ebb and flow from moments of fear to moments of euphoria. This is how financial markets shift from bull to bear markets. It is also how emotions of “The Herd” transfer through financial assets like a continuum from fear to greed traveling through phases of despondency, optimism, and thrill as you can see here.

Warren Buffett is essentially suggesting investors that are able to keep this continuum in mind over long periods of time (AKA: Play long ball) with a willingness to be patiently contrarian when extremes develop in emotions and prices, on both sides of the continuum, tend to manage the risks associated with investing much better than short term thrill-seekers.

There is an art and a science to mastering this process and for most investors, it can take years to be able to recognize where markets and economies may be within this continuum. Luckily for you, we can save you a lot of time and energy as we have been tracking and gathering data on these ebbs and flows for over two decades and it is applied to each of the models we manage for our clients.