Human Weakness in Investment – Herd behaver

We almost cannot live without the Internet now. If you are not too young, you must remember the dot-com bubble in 1995–2001. Over the period, investors were crazy about companies in the Internet business and were ready to buy these companies at any prices. On the other hand, companies could cause their stock prices to increase by simply adding an “e-” prefix to their name or a “.com” suffix, which one author called “prefix investing”. By the end of the 1990s, the NASDAQ hit a price-to-earnings (P/E) ratio of 200. Many companies disappeared afterwards and many crazy investors, or rather speculators, in this dot-com rush lose their money.

How could this kind of crazy thing happen repeatedly in history? It’s herd behaver at work.

During the dot-com boom period, as internet stocks rose, investors who owned the shares got rich on paper. This exerted influence on those who did not own the shares and many of them ended up suspending belief and buying as well. This fed the process.

Imagine 100 potential rioters milling around in a public square. Each individual has a “riot threshold,” the number of rioters that person would have to see in order to join the riot. Say one person has a threshold of 0 (the instigator), one has a threshold of 1, one has a threshold of 2, and so on up to 99. This uniform distribution of thresholds creates a domino effect and ensures that a riot will happen. The instigator breaks a window with a rock, person one joins in, and then each individual piles on once the size of the riot reaches his or her threshold. This is the typical pattern of herd behaver. It happened everywhere in human history. The dotcom rush was one of them.

Great investors go purposely against the herd in investment. As Buffett says “we try to be greedy when others are fearful and fearful when others are greedy.”

A great investor has his own scoreboard and does not care what others think of him. He makes his investment decision based on the relevant information, his own analysis and reasoning, not based on what everybody else thinking, or doing.

This is the fundamental difference between excellence and mediocrity not only in investment, but also in other aspects of live.