“If everyone is thinking alike, then no one is thinking.” Benjamin Franklin
Few years ago, thousands of social media users participated in the ‘ice bucket challenge’. By filming themselves being drenched with buckets of ice water, the challenge became viral in no time. Why did everyone jump onto such an illogical act?
Well, our instinct of following the herd probably comes from our desire to be on the winning side and an equally strong desire to fit in. This human tendency of blindly following others is called the Bandwagon effect. This is especially true of investors.
When you are driven by the powerful desire to get the best returns, it can be very tempting to crowd into a hot stock or sector where there’s so much buzz and excitement. But is it good or bad?
The problem is that following the crowds is not always safe. Are you following everyone to the treasure-trove? Or over the edge of a cliff?
What would happen if the majority of investors and traders become imitators? If they all buy stocks just because others are doing so, then this might land them in a bubble.
When the stocks are not bought based on data and logic, their underlying value is often misjudged. Eventually, when some investors realize the hike is unsustainable, they start to sell off the shares. Other investors follow the bandwagon quickly, resulting in the decline of the stock price. Interestingly, this type of herding behavior is often seen when investors rush to buy stocks at the peak or rush to sell stocks at the market’s bottom.
Investors blindly fall prey to the block deals/bulk deals often made by smart and big investors without knowing the reasoning behind it, their risk appetite and time horizon, which may differ from yours.
The Archegos margin call event and the Gamestop saga are some of the illustrations of the Bandwagon effect. Is it possible that once two or three brokers provided the financing to Archegos, the others followed along? On the other hand, the combined action of individual investors sent GameStop shares soaring up over 800% earlier this year. The stock later took a significant tumble. While some investors who jumped on the GameStop bandwagon made money, there were likely many others who timed the transaction wrong and lost out.
Our financial history is full of such bandwagon examples – the dot.com bubble, the 2008 housing crisis in the US and last Mar’20 panic selling. Indications of the bandwagon effect sometimes come from IPO space too. If the offering has been over hyped and investors sense that the stock could do very well, they may rush to get onto it.
Be it your fashion trends, or a dance style going viral, they all saturate after a point and go out of fashion. The same goes for investing too. Before you jump onto a bandwagon, consult a professional investment manager for guidance. And even if you were to follow the tempting trend, ensure that you do not risk too much capital, have a diversified exposure, and stick to a strict trailing stop loss. This way, even if the worst has to happen you are not left high and dry.
So, next time when stock markets rise or collapse, find out whether it's logical or is it just the bandwagon effect!
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