Remember the IPO craze in 2024-25? Small businesses that had never been public before suddenly saw their stock being bid up hundreds of times within just days. They experienced an overwhelming influx of interested investors. Social media was filled with posts touting the potential returns on these new investments, and almost everyone knew someone who had invested too.
And then...the bottom fell out of almost all of them. What happened? You guessed it. Herd behaviour is one of your biggest threats to making money over the long term.
How do stocks become so expensive?
So how does herding behaviour lead to overpriced stocks? Basically, when a particular group of stocks or sectors go viral, there is a huge influx of investors, the Fear of Missing Out (FOMO) ones buying those stocks at the same time. That creates a rush to get those stocks before anyone else gets them, and prices rise dramatically.
But here is the thing: the price no longer reflects the value of the underlying business; it now represents how excited the crowd is about it. Therefore, the more popular an asset becomes, the less likely you are to get a fair deal.
Why You Pay a “Trend Premium”
The herding behaviour leads investors to ignore fundamental analysis. Investors will stop looking at the company's cash flow statements, or any other analysis and buy based solely on whether the price is going up.Think back to the period leading up to the 2024-25 bubble.
Many investors ignored the fact that companies had significant debt burdens to 'ride the trend.' As a result, many investors purchased companies that lacked a strong financial footing. If you follow the crowd, you tend to pay a 'trend premium' for a poor-quality asset.
Risking your portfolio with speculative bets
Herding behaviour also puts you at risk of having an imbalanced portfolio. A large number of investors put their entire retirement account into speculative IPOs instead of investing their retirement funds in balanced, low-risk mutual funds. Consequently, the financial security disappears overnight.
Further, if a portion of your investment account is heavily weighted in one particular area, you eliminate the protection provided by diversification. A downturn in that particular sector could wipe out your entire portfolio.
Selling panic leads to the final price Crash
On the other hand, getting out of an investment trend is usually a messier process than getting into one. At some point, the hype surrounding an investment will die down, and reality will set in.
Once several early investors, the hype builders, sell to take advantage of their profit margins, the rest of the crowd catches wind and sells quickly. This creates a panic sale situation, and every investor wants out at the same time. The resulting price drop is usually severe and lasting. Late investors bear the brunt of the losses.
Data vs Drama - Trust facts, not trends
In summary, while herding behaviour can negatively impact long-term investment outcomes when it leads investors to ignore fundamentals and does not generate wealth. We help our clients at Shriram Wealth avoid this trap by encouraging you to rely upon facts rather than emotions.
Investing using data-driven decisions allows you to protect yourself from future cycles of mania. True financial peace results from developing a strategy that is both disciplined and free from emotional influences, not from blindly following the crowd's opinions.
