What is conventional wisdom?

Challenging the Herd: What Is Conventional Wisdom?

Nov 12, 2024

Imagine standing in a crowded marketplace where everyone rushes towards a single stall, convinced it’s offering the best deal. Do you follow the crowd or question what they see that you don’t? In the investment world, this scenario plays out daily, and it’s known as following conventional wisdom. But what if this collective belief is steering you away from real opportunities?

Conventional wisdom refers to widely accepted beliefs or ideas that are considered true without critical examination. In finance, it often manifests as investment trends or strategies that the majority accept as the norm. While following conventional wisdom can provide security, it may also lead investors into pitfalls, especially when mass psychology and herd mentality override rational analysis.

The Illusion of Safety in Numbers

The stock market crash of 1929 serves as a historical testament to the dangers of blind adherence to conventional wisdom. During the Roaring Twenties, the prevalent belief was that stock prices would continue to rise indefinitely. This optimism led to rampant speculation, with individuals mortgaging their homes to invest in the market. The euphoria ignored underlying economic weaknesses. When the bubble burst, it triggered the Great Depression, wiping out the savings of countless investors who had trusted the collective optimism.

This event underscores how conventional wisdom can create an illusion of safety in numbers. Behavioural finance explains this through herd mentality, where individuals mimic the actions of a larger group, assuming that the majority cannot be wrong. This behaviour often amplifies market trends, leading to excessive valuations or drastic sell-offs disconnected from fundamental values.

Mass Psychology: The Driver Behind Market Movements

Human emotions play a significant role in financial decisions. Fear and greed are powerful motivators that can overshadow logical analysis. During the dot-com bubble of the late 1990s, investors were gripped by the fear of missing out on the next big tech company. Conventional wisdom suggested that any company related to the internet was a goldmine. This led to astronomical valuations of companies with little to no earnings.

When the bubble burst in 2000, the Nasdaq Composite index plummeted by nearly 80% over two years. Investors who had bought into the hype suffered massive losses. This market collapse highlighted how mass psychology, fueled by greed and the desire to follow prevailing trends, can lead to irrational investment decisions.

Technical analysis offers tools to navigate beyond conventional wisdom by examining statistical trends gathered from trading activity. Indicators such as moving averages, volume trends, and relative strength index (RSI) can reveal underlying market sentiments that are not immediately apparent. For instance, a divergence between a stock’s price and its RSI can signal a potential reversal, alerting investors to reconsider their positions.

During the housing bubble of the mid-2000s, technical indicators showed warning signs that were largely ignored due to prevailing beliefs that real estate prices would perpetually rise. The S&P/Case-Shiller Home Price Indices began to show a plateauing of home prices even as mortgage lending continued at a breakneck pace. Investors who paid attention to these signals could have anticipated the impending crash, avoiding significant losses.

Contrarian Thinking: The Antidote to Conventional Wisdom

Contrarian investors thrive by going against prevailing market trends, challenging conventional wisdom to uncover undervalued opportunities. This approach requires a keen understanding of mass psychology and the discipline to act independently of popular opinion. Legendary investor Sir John Templeton famously said, “Bull markets are born on pessimism, grow on scepticism, mature on optimism, and die on euphoria.” Recognizing these phases allows contrarians to buy when others are selling and sell when others are buying.

During the financial crisis of 2008, while panic gripped the markets, some investors recognized the overselling of fundamentally strong companies. They strategically bought shares at depressed prices, leading to significant gains in the subsequent market recovery. This strategy hinged on resisting the fear that dominated the market and trusting in thorough analysis over collective panic.

Investors often experience a predictable emotional cycle influenced by market fluctuations. At the market’s peak, euphoria can lead to overconfidence and increased risk-taking. As the market declines, denial and fear set in, leading to rash decisions like panic selling. Understanding this cycle is crucial for making rational investment choices.

A study by DALBAR found that the average investor underperforms the market due to behavioural biases, primarily the tendency to buy high during optimistic periods and sell low during pessimistic ones. By recognizing these emotional responses, investors can develop strategies to mitigate impulsive decisions driven by conventional wisdom.

Timing Is Everything: Strategic Buying and Selling

Effective investment timing involves recognizing when market prices deviate significantly from intrinsic values. Technical analysis can help identify these moments. For example, the price-to-earnings (P/E) ratio can indicate whether a stock is over or undervalued compared to its historical average or industry peers. During the dot-com bubble, some companies had P/E ratios in the hundreds or even thousands, signaling extreme overvaluation.

Strategic buying during market crashes requires the courage to act against prevailing pessimism. In March 2009, the S&P 500 reached a 12-year low at the height of the financial crisis. Investors who recognized the market was oversold and bought at this point benefited from one of the longest bull markets in history, as the index more than quadrupled over the next decade.

Fear and euphoria are powerful emotions that can cloud judgment. Euphoria can lead to speculative bubbles, as seen with the cryptocurrency surge in 2017. Bitcoin’s price skyrocketed from under $1,000 to nearly $20,000 within a year, driven by hype and the belief that prices would continue to rise indefinitely. When reality set in, the price plummeted, leaving late entrants with significant losses.

Conversely, excessive fear can create buying opportunities. During the COVID-19 pandemic’s onset in March 2020, global markets experienced sharp declines due to uncertainty. Investors who managed their fear and invested in strong businesses during the downturn benefited from the rapid recovery, as markets rebounded to record highs within months.

Questioning Conventional Wisdom: A Path to Clarity

Challenging conventional wisdom requires critical thinking and a willingness to diverge from the majority. It’s essential to conduct independent research, assess fundamentals, and understand the psychological factors at play. This approach doesn’t guarantee success but increases the likelihood of making informed decisions aligned with one’s investment objectives.

Investors can also benefit from studying market history to recognize patterns influenced by collective behaviour. Understanding past events, such as the South Sea Bubble or the Tulip Mania, can identify similarities in current market conditions that may signal irrational exuberance or unwarranted pessimism.

Conclusion: Redefining Investment Success

Conventional wisdom offers comfort but can lead investors astray when it’s driven by mass psychology rather than sound analysis. Recognizing the impact of herd mentality, emotional biases, and the importance of timing can empower investors to make more rational decisions. By questioning widely held beliefs and embracing contrarian strategies when appropriate, investors position themselves to navigate market cycles with greater confidence and clarity.

The investment journey is as much about understanding human behaviour as financial metrics. By shedding reliance on conventional wisdom and fostering independent thought, one can transform challenges into opportunities, attaining financial gains and intellectual fulfilment. After all, true success in investing often comes from seeing what others do not and having the conviction to act on that insight.