The Perils of Following the Flock: Understanding Sheep Mentality

Sheep Mentality in Trading and Investing

Updated Jan 31,2024

We’ll commence this article by sharing excerpts from previous market update issues that vividly demonstrate the “herd mentality.” It’s important to use historical context to analyze specific problems because those learning from history are less likely to repeat past mistakes. History may not repeat itself precisely in financial markets, but it certainly rhymes.

Traders that are driven by fear lose on both ends of the trade; they don’t short the markets or go long. Shorting the markets is not a recommended course of action when the trend is positive. However, at least one is attempting to do something instead of letting fear take over. After that harrowing experience, they have nothing to show for it other than an even larger appetite to be taken to the cleaners at some future date. This is sometimes referred to as the secret desire to lose syndrome. Market Update Sept 9, 2020

Before we continue, remember the expression or sayings such as misery loves company and or the Tactical Investor’s variation that adds a second part, and stupidity simply demands it. Or another two TI saying Riches come to those who seek it, or the early bird gets the worm and the late one the bullet. No matter how hard one tries, one cannot change the order.

The deeply ingrained sheep mentality that characterizes the masses has long been a losing strategy. The stark reality remains inexplicably elusive to many: fear is a pauper’s reward. Therefore, the history of the markets serves as a warning that those who fail to heed the lessons of the past are destined to replicate their failures with astonishing precision. Only through the steadfast application of a contrarian and tenacious mindset can one hope to navigate the treacherous waters of the financial world with any degree of success.

The Dangers of Groupthink in Trading and Investing

Peter Lynch, a Wall Street legend, is renowned for having generated annualized returns of 29% between 1977 and 1990, a feat that helped propel Fidelity’s Magellan assets past the $14 billion mark. One would naturally assume that those who invested in his fund would have reaped similar rewards. But alas, the human propensity to self-sabotage, the so-called “secret desire to lose syndrome,” prevailed, and most of the investors in the fund lost money.

How could this be? It is simple: fear pays poorly. The masses are wired to panic and flee at the first sign of danger, stampeding towards the hills like a herd of frightened animals. This explains why so many of our new Tactical Investor subscribers panicked when the markets sold off in March, while the more seasoned investors who had read our suggested materials and past market updates embraced the pullback and reaped significant rewards. Though both groups subscribed, their outcomes were vastly different. In investing, remaining calm and rational, even in the face of adversity, separates the wheat from the chaff.

The Dark Side of Conformity: Risks of Sheep Mentality

In the same vein, the primary reason that so many Magellan fund subscribers lost money was that they tried to outdo Peter Lynch himself. They bought into the fund when it was performing well and sold when things looked dire, a perfect recipe for financial ruin. It is for this reason that we view performance statistics as meaningless. A much better approach is to scrutinize past material and draw your conclusions because even when one person walks away with 100% in gains, the other could technically lose everything.

Returning to Peter Lynch, the truth is that most investors jumped into the fund when it was doing well and sold when it was performing poorly. Instead of buying low and selling high, they made the cardinal mistake of buying high and marketing at the bottom. Fidelity conducted a comprehensive study, and the results were truly eye-opening. Not only did the average investor fare poorly, but they failed even to break even. It is almost unimaginable that a fund with such outstanding returns could have failed to reward its investors. The only reason that comes to mind is sheep mentality—following the losers to the end of the slope. In other words, they were doing what they were not supposed to do at precisely the right time.

What is the lesson here?

The simple truth is that, no matter how talented the fund managers may be, irrationality invariably trumps logic. Investors let their emotions govern their decisions, buying based on greed and selling based on fear. The net result is that such a strategy offers virtually no chance of success.

As we anticipate the market soaring to unprecedented heights, it is worth remembering that most investors will find it challenging to generate meaningful returns, for they will follow the same tired playbook. This means that the savvy Tactical Investors who read our past market updates and other materials will have the opportunity to make out like bandits.

Bearish sentiment rose slightly, note that this data was collected before the markets started to sell off. Remarkably Bullish sentiment is now trading below its historical average for over 30 weeks in a row. While bearish sentiment refuses to drop below 33.00. All in all, this means that no matter what the expert’s state, every healthy pullback ranging from mild to wild has to be embraced without exception. Market Update Sept 9, 2020

Sheep Mentality 101: Fear Pays Poorly

The dynamic nature of the market landscape is often accompanied by a pervasive sense of anxiety, as indicated by the prevailing bearish sentiment, which has reached an astonishing 49. However, delving deeper into the root cause of this turmoil reveals a common thread: uncertainty. Uncertainty, with its ability to sow doubt and hesitation, influences market participants and shapes their reactions. It is within this context that the significance of the relatively steadfast neutral camp becomes all the more intriguing. Over the past weeks, the number of individuals residing in this camp has remained remarkably stable, with last week’s reading at 27 and this week’s reading mirroring it at 27, as if firmly anchored within this range.

In the market, we encounter many individuals who tend to swiftly shift allegiance, moving from the bullish camp to the bearish camp and vice versa, in response to the ever-changing tides. This reactionary behaviour, akin to a pendulum swinging erratically, provides ample fodder for those who revel in chaos, the metaphorical guillotine masters who relish the perpetual stream of heads in such an environment.

However, it is essential to recognize that this environment of uncertainty and rapid shifts in sentiment can also present opportunities for those who approach the market with a steady hand and a long-term perspective. While it is natural for emotions to influence decision-making in such a volatile landscape, a measured and disciplined approach can help circumvent the pitfalls of reactionary behaviour. Individuals can navigate the market’s ebbs and flows with greater resilience by focusing on thorough analysis, risk management, and a commitment to one’s investment strategy.

It is through this deliberate and composed approach that market participants can maintain a sense of stability amidst the ever-changing currents, allowing them to make informed decisions rather than being swayed by the whims of sentiment. By focusing on the underlying fundamentals, conducting thorough research, and cultivating a long-term perspective, investors can steer clear of the guillotine master’s allure and instead position themselves for success in the market’s unpredictable landscape.<

We have lemmings jumping back and forth from the bullish to the Bearish camps; this is the guillotine master’s dream come true, for the supply of heads is endless in such a setup.

If the current support at 27460 does not hold, then a break of 27K is expected at least on an intraday basis. Now, the normal reaction for novice traders is to panic at the thought that the markets could trend lower. In doing so, vital energy is wasted on viewing an opportunity through a negative lens. Individuals that take this approach are usually like deer frozen in front of a speeding truck. The glare of the headlights impairs their judgement, so even though they could quickly jump out of the way, fear keeps them frozen in place until the inevitable transpires. Market Update Sept 9, 2020

Embrace the Trend, for it’s your friend.

The crowd views disasters such as sharp pullbacks or so-called crashes through a negative lens because that is how they have been conditioned to react. Like a good computer, their minds follow the programming to a T; run in the face of panic and buy in the face of joy. Tactical Investor

The recent drop of the Dow to 27065 and the continued volatility in V-readings have generated a state of flux and uncertainty. As the Dow has followed the anticipated trajectory, we expect it to revisit the 27,000 range, given the extreme market conditions. However, it is essential to note that the trend remains positive, and as Tactical Investors, we must capitalize on these setbacks and fearlessly explore new opportunities.

Adopting this unconventional approach to adversity sets us apart from the masses, who view sharp pullbacks or market crashes through a negative lens. They are held captive by their minds’ conditioning, programmed to react robotically—flee when panic strikes and buy when joy abounds. We must break free from this rigid mindset and celebrate in the face of market chaos, as it is during these tumultuous times that significant opportunities for gain reveal themselves.

The Pitfalls of Sheep Mentality in Trading and Investing

In the treacherous terrain of the market, the sheep mentality is a trader’s Achilles’ heel. It’s a psychological snare that has ensnared investors repeatedly, from the tulip mania of the 17th century to the dot-com bubble and the subprime mortgage crisis. The herd’s march can lead to the edge of a precipice, where one misstep, fueled by collective euphoria or panic, can result in a freefall.

Consider Warren Buffett, the Oracle of Omaha, who famously advised to be “fearful when others are greedy and greedy when others are fearful.” His success is a testament to the power of counter-cyclical action, a stark contrast to the herd’s often ill-timed stampedes into and out of the market. Buffett’s approach is surgical, eschewing the cacophony of the crowd for the quiet deliberation of value investing.

Then there’s George Soros, who broke the Bank of England, whose Quantum Fund executed a strategic short sale against the pound sterling, capitalizing on the herd’s blind spot. Much like a grandmaster in chess, Soros’ philosophy involves thinking several moves ahead, anticipating market shifts before they become apparent to the masses.

Ray Dalio, another giant in the realm of investing, preaches the gospel of radical transparency and diversification, challenging the conventional wisdom of the herd. His ‘All Weather’ investment strategy is designed to weather storms that would otherwise capsize the unprepared, those who move in lockstep with the crowd.

The sheep mentality in trading and investing is not just a pitfall; it’s a chasm that has swallowed fortunes whole. The market’s history is littered with the remnants of those who moved with the herd rather than those who, like Buffett, Soros, and Dalio, observed from a distance, waited for the opportune moment, and then struck, turning the herd’s momentum to their advantage. Independent thinkers and contrarians survive and thrive in the market’s unforgiving arena.

The Sheep Mentality and Its Impact on Financial Markets

The pernicious effects of the sheep mentality in financial markets are well-documented. An array of studies crystallizes the dangers of this behaviour, particularly in trading and investing. For instance, the Journal of Financial Markets research underscores how mutual fund managers are not immune to the herd’s pull. Their tendency to mirror the choices of contemporaries rather than relying on intrinsic stock value has been shown to dilute returns, a disservice to investors who entrust them with their capital.

Ancient wisdom offers insight into modern market follies. Aristotle’s call for moderation resonates with the investor who must navigate between the Scylla and Charybdis of fear and greed. Similarly, Plato’s cave allegory parallels the investor’s plight, trapped by the shadows of market sentiment rather than the substance of market fundamentals.

Further empirical evidence from the Journal of Behavioral Finance examines the spectacular rise and fall of the dot-com era. It highlights how rampant speculation, fueled by a herd mentality, drove valuations into the stratosphere, far removed from economic reality. When the bubble burst, it was a clarion call about the herd’s might to distort markets.

The 2008 crisis is another stark example, with the herd’s blind march into complex mortgage-backed securities resulting in a systemic collapse. A study in the Review of Financial Studies analyzes how the contagion of optimism among banks and investors amplified the bubble and intensified the crash. These institutions, caught in the herd’s momentum, failed to recognize the precariousness of the situation until it was too late.

These studies remind us that the market is unforgiving to those who forsake independent analysis for the comfort of consensus. They echo the teachings of great thinkers like Aristotle and Plato, emphasizing the need for balance, critical thinking, and the pursuit of knowledge. Investors who heed these lessons, who look beyond the herd’s clamour, stand to navigate the markets with discernment, leveraging the herd’s missteps into personal gain. Through such informed independence, the true market opportunity is realized, and financial calamity is averted.

Navigating Market Volatility: Overcoming Sheep Mentality with a Disciplined Approach

The financial markets, inherently volatile, reward those who resist the herd’s momentum. Empirical evidence underscores the costly missteps of herd behaviour. A Journal of Financial Markets study spotlights mutual fund managers mimicking peers rather than making independent stock assessments, often at the expense of return on investment.

Similarly, the Journal of Behavioral Finance scrutinizes the dot-com bubble’s inflated valuations, attributing the frenzy to a widespread herd mentality that disregarded fundamentals. The Review of Financial Studies echoes this sentiment, analyzing the 2008 financial crisis, where a collective overconfidence in mortgage-backed securities precipitated a market implosion.

Invoking Archimedes’ principle of leverage, one might argue that a single investor, with the right tools and fulcrum—a disciplined strategy and solid research—can move the market. Just as Archimedes sought precise points to apply force, so must investors identify strategic entry and exit points, resisting the push of the herd.

Similarly, the scepticism of Socrates, who relentlessly questioned popular opinion, is valuable for investors. The Socratic method, applied to investing, encourages a rigorous interrogation of market sentiment, company performance, and one’s biases, ensuring that investment decisions are not based on the herd’s shadow but on the substance of reasoned analysis.

To navigate market volatility:

1. Education and Research: Commit to understanding market mechanisms and investment principles. Seek wisdom in financial history and current trends.

2. Define Investment Goals and Risk Tolerance: Articulate your financial aspirations and how much uncertainty you can stomach. This self-knowledge is foundational for building a strategy that endures market swings.

3. Develop an Investment Plan: Construct a tailored plan for your goals. It should detail asset allocation and diversification to spread risk across various market scenarios.

4. Maintain Long-Term Perspective: Focus on the horizon, not the waves. Markets will fluctuate, but a steadfast focus on long-term objectives will guide you through volatility.

5. Risk Management Strategies: Protect your portfolio with mechanisms like stop-loss orders, ensuring that market dips don’t become financial dives.

6. Monitor and Review: Monitor and review your investments, adjusting as necessary but not so frequently that you’re swayed by every market ripple.

7. Patience and Discipline: Uphold your investment plan with stoic resolve. The market often tests your strategy, but patience and discipline are your bulwarks against rash decisions.

In the markets, those who stand firm in their convictions, guided by thoughtful analysis and strategic foresight, prevail. The disciplined investor, much like an ancient philosopher, uses knowledge as a compass and strategy as a map to find success amid the market’s tumultuous seas.