Professor Aswath Damodaran, who teaches corporate finance at the Stern School of Business at New York University, once stated that the seven deadliest words of investing (words that explain irrational investing behavior) are the following:
“They must know something that you don’t.”
It’s these words that explain herd behavior in the stock market. It’s why investors rush in and out of the market in herds without rhyme or reason. Often, an individual investor acting alone is more prone to analyze and evaluate opportunities based on rationale, economic metrics, and numbers. But put a bunch of these individuals into a herd, and they start acting irrationally based on the reasoning that if everyone else is doing it, then it can’t be all that bad, right? “They must know something that you don’t.”
The study of herds and herd behavior is not a new phenomenon.
“Men, it has been well said, think in herds; it will be seen that they go mad in herds while they only recover their senses slowly, and one by one.” -Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds, 1841
Herd behavior can be deadly in investing, but not all the members in the herd are acting on the same impulses. Professor Damodaran compared investors to lemmings – willingly and mindlessly following the herd off the cliff on the slightest impulse. And in comparing investors to lemmings, Professor Damodaran made a distinction between three types of lemmings – explaining that all investors are one of the three types of lemmings to some degree.
Lemming #1 – The Proud Lemming.
This lemming is proud to be part of the crowd – following what’s hottest or chasing the latest shiny object. They go along with whatever is getting the herd excited – whatever the latest stock or crypto of the month generating the latest internet and social media hype and buzz.
This type of herd behavior is in line with the fear of missing out (FOMO), where this lemming will do whatever to be included in the herd. Fundamentals are damned with this type of lemming. All they care about is what the crowd is doing and mimic what is being bought and sold by the crowd.
Lemming #2 – The Yogi Bear Lemming.
This lemming thinks it can get out in front of the crowd. Yogi Bear’s famous tagline was that he was “smarter than the average bear,” and this lemming thinks he’s smarter than the crowd as well – able to get out in front of the market before price bumps and able to jump ship before crashes.
Just as Yogi Bear often looks like a fool in his cartoons, this lemming seldom outsmarts the crowd and ends up going over the cliff anyway.
Lemming #3: The Lemming With A Life Vest.
A lemming with a life vest is a lemming that thinks a little bit differently than the crowd. They’re still part of the crowd but typically don’t go all-in with the crowd and can sometimes survive the herd going over the cliff because they have a life vest.
During the dot com bubble, Warren Buffett was a lemming with a life vest. He was still part of the herd – still investing in the stock market – but he didn’t go all-in with the crowd. Buffett knew that dot com stocks were overvalued in 2000 and stuck to his guns. While the media vilified him and called him “old,” Buffett didn’t bend and was spared the major losses the herd took when the bubble burst.
While Professor Damodaran boxes every investor into one of the three groups of lemmings, the truth is, you don’t have to be a lemming at all. A whole group of other investors – savvy investors – choose not to be lemmings. Wall Street and society, in general, say otherwise, but every investor has the choice to be a lemming or not.
Savvy investors remove themselves from the Wall Street crowd and play in a different space. By investing in private markets, they take power and influence over investment decisions out of the hands of the crowds so they can focus on the fundamentals.
With illiquid private alternative assets like private equity and real assets, savvy investors take the crowds out of the equation.
Private investments allow them to focus more on relevant factors such as analytics, math, supply, demand, income, and macroeconomic factors like employment and focus less on irrelevant factors such as what the crowd is doing or buzzing about.