“Following the Herd” Mentality
Written by Brian McKinney, CFP®
Published in the Baltimore Business Journal on June 12, 2020
In investing, as it is in life, the value of something is often very difficult to determine. In 1st century BC, Publilius Syrus wrote: “Something is only worth what someone is willing to pay for it.”
Birth of the Herd Mentality
No better example of this exists than what occurred during the mid-1600s in Holland. Coined “tulipmania,” the Dutch tulip bulb market bubble was one of the most famous market bubbles and crashes of all time. Intense speculation drove the value of tulip bulbs to extremes. At the height of the market, the rarest tulip bulbs traded for as much as six times the average person's annual salary. As the price continued to skyrocket, people thought the price would never stop rising. They continued to invest in tulips believing they could sell them at a higher price tomorrow. After tulips became so expensive, the cost of a single bulb exceeded that of an average home, the price collapsed, and many investors went bankrupt.
Due to extensive research in the field of behavioral finance, we now have a term to describe this irrational behavior: herding. Other well-known herd behavior-driven market crashes include the Roaring 20s, the dot-com bubble, and the housing bubble.
Herding refers to the instinctive habit of people to imitate the financial behavior of a majority. Herding is based on the idea that people feel most comfortable following the crowd and tend to assume that the consensus view is the correct one. In financial markets, this takes place when investors believe others to be better informed than themselves and follow them almost blindly, disregarding their own information and market fundamentals.
Recent Examples of Herd Mentality
No matter the century, there will always be herding. The most recent examples in the markets can be seen by the large run-up and subsequent price collapses in cryptocurrencies and marijuana stocks. A notable run-up that most investors are familiar with is the Bitcoin craze of 2017. At the beginning of 2017, Bitcoin was trading below $1,000, and on December 17, 2017, Bitcoin reached its all-time high of $19,738.21. That close encounter of $20,000 was followed just days later by a 30% drop that shaved billions of dollars off of the total cryptocurrency market capitalization (CoinDesk). As of December 31, 2019, Bitcoin was trading at $7,193.60 which represents a price drop of over 63% from the peak levels it reached in December 2017.
Another recent example of herding behavior can be seen in the marijuana stock craze. One of the most talked about marijuana companies is Tilray. Tilray, which trades on the NASDAQ, reached an all-time high closing price of $214.06 on September 19, 2018. But, after the herding stopped, Tilray ended 2019 at $17.13, representing a price drop of over 90% (Macrotrends).
As illustrated by the examples above, herding can lead to prices that far exceed their fundamental value. However, as the number of buyers gets smaller and smaller, eventually, the propped-up price will come crashing down as the herd leaves to find the next exciting investment.
The next time you are thinking about investing in something only because the price has skyrocketed and everyone else is doing it, consider reaching out to a financial advisor for a second opinion.
*This article is intended strictly for educational purposes only and is not a recommendation for or against cryptocurrency
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