Herd Mentality and Contrarian Investing

Herd mentality is a psychological phenomenon that occurs when people adopt the opinions and behaviors of a group and is often seen when people feel uncertain or under pressure.

Herd mentality can have a powerful influence on people's behavior. In some cases, it can lead to positive outcomes, such as when a group comes together to achieve a common goal. But it can also have negative consequences, such as when people conform to harmful stereotypes or engage in risky behavior.

In investing, herd mentality, or herding, is evident in the large combined capital of the investing public, leading to strong trends in asset prices. Herding is similar to groupthink and crowd psychology. Investors may blindly follow the crowd without stopping to think about what they're doing. Herd mentality can lead to irrational decisions and poor investment choices.

Unlike contrarian investing, where investors seek to allocate capital in ways that are opposed to the thinking of the majority of the public, herding typically follows the biases of the masses, often because it appears “safe.” Herd mentality can lead to strong price trends and asset bubbles.

Individuals in a group may be more likely to go along with the opinions and behaviors of the majority, even if those opinions or behaviors are illogical or harmful.

Contrarian investing is built upon the notion of profiting from mis-priced assets that result from one-sided investing. A contrarian investor looks for investments that are out of favor with most investors and therefore undervalued.

Contrarian investing involves making investment decisions that are contrary to the current prevailing wisdom. By definition, contrarian investors must be willing to go against the herd. To succeed, contrarians must clearly understand why the majority is wrong, and their investment thesis is correct.

Investing contrarily requires both conviction and courage. Conviction to stay the course when everyone else is selling and courage to buy when everyone else is selling.

The contrarian investor seeks to buy assets when they are undervalued and sell them when they are overvalued. Contrarian investing is a long-term strategy that can be difficult to implement, as it often goes against the natural human tendency to follow the herd.

Many sentiment and market studies, such as the put/call ratio, are contrarian indicators where investors seek to benefit from a change in the direction of the investing herd. Strategies such as mean-reversion trading also capitalize on contrarian thinking as investors look for retracements from strong, one-sided, trending price action.

Mean-Reversion Trading

Mean-reversion trading is a contrarian investment strategy that looks to take advantage of overreactions in the market. The theory behind mean-reversion trading is that prices tend to return to the mean or average price over time.

Mean-reversion trading strategies bet against extreme moves in the market, expecting that the price will eventually revert to the mean. These strategies often use technical analysis to identify overbought or oversold conditions in the market.

While herd mentality can lead to positive and negative outcomes, contrarian investing is a strategy that seeks to profit from market moves driven by herding behavior. By definition, contrarians must be willing to go against the herd, which can be a difficult and risky proposition.

FAQs

1. What is herding in finance?

   Herd mentality is an investor bias behavior exhibited by individuals influenced by the collective group into thinking and behaving similarly as the group. In investing, herd mentality, or herding, is evident in the large combined capital of the investing public, leading to strong trends in asset prices. Herding is similar to groupthink and crowd psychology.

2. What causes herd mentality?

   Herd mentality typically follows the biases of the masses, often because it appears “safe.” Herding is the behavior exhibited by individuals who are influenced by the collective group into thinking and behaving similarly as the group. Herd mentality can lead to strong price trends and, ultimately, asset bubbles.

3. What is an example of herd behavior?

   There are numerous examples of herd behavior in financial markets throughout history. Herd mentality is most often seen in asset bubbles and stems from a fear of missing out. The tech bubble in the early part of the 21st century is a prime example of herd behavior, as investors poured money into the stock market without regard for earnings prospects, proper research, or risk management.