Don’t be a Lemming…choose well when it comes to taking risks
Two well-documented subjects in behavioural economics are the “herd mentality” and “the bandwagon effect”. Simply put, we tend to look at what the rest of the market is doing and follow suit, regardless of whether the response is aligned to stock market fundamentals, to our unique needs or to common sense. These traits made me think of lemmings, those odd creatures anecdotally famous for one thing: following their herd over the edge of a seaside cliff. While humans and market participants are (hopefully) slightly smarter, are we that different?
Predictability, especially in investing is humanly impossible
We find it difficult to stomach volatility, in any sphere of life. We do not want our significant others; our business partners, bosses or employees; or even our favourite soccer team to be unpredictable. We prefer predictable outcomes. This is especially true when it comes to our investment portfolios – we would like our nest egg to be safe from the whims of a capricious market. Unfortunately, due to our very human instincts, it is not always as simple as it may seem.
Consider the fact that there is a reason why herd behaviour is associated with a mob or pack mentality. Decisions are no longer based on one’s own needs, an independent and well-thought-through view, or credible research. We get swept up in the general chaos of groupthink. The results can often be spectacular (albeit in the same way that the implosion or demolition of a building is spectacular). Panic buying, panic selling, asset bubbles inevitably burst, and market crashes. Billions are wiped out, sometimes over the course of a week or even a day. We tend to think that these downright-frightening events only affect the upper echelons of the market, the large institutional investors or high-net-worth individuals who have money to burn.
Realistically, the little guy is potentially more likely to be taken out when a bubble bursts or a market crashes. We are typically unable to protect ourselves or our hard-earned money from episodes of extreme volatility. No, we are not saying keep your cash under the mattress, though that may be our initial instinct. We are suggesting that we acknowledge our instincts and manage them in ways that are aligned with our end goal. When it comes to our investment portfolio, the end goal varies – from a comfortable retirement to accumulating enough to send our children to university, to finally paying off our home loan.
The crypto craze that soon became an investment fad
Counter-intuitively, doing nothing during episodes of heightened market volatility may be the best thing to do. Sometimes, not being “trendy” might mean initial discomfort as we combat the urge to jump on the bandwagon. Let us think about it carefully, not too long ago, everybody was suddenly a crypto trader. Bitcoin and its myriad offshoots were “the bees”’ knees. Come 2022, the crypto party ended abruptly. From May 2022, we saw a string of failures, including notoriously the crypto hedge fund called Three Arrows Capital. Bitcoin lost more than 75% of its market value over the course of the year. The so-called crypto winter exposed firms that were overextended, highly leveraged, or had generally poor risk management.
With little to no understanding of the nuances of investing in an asset class in its relative nascency, and with limited ability to withstand the volatility associated with a largely unregulated investment/asset class… the little guys got smashed. Sleeping on a mattress filled with Bitcoin might have been more comfortable than the 2022 market crash.
Taking calculated risks sometimes pays off
Hard as it is to believe, volatility is not always a bad thing. Sometimes, elevated volatility allows astute investors to buy attractive assets at a relatively low price. We have seen a recent example in the local stock market. Naspers/Prosus, once the darling of portfolio managers, peaked in 2021 and then nosedived spectacularly. Several factors were at play. In China, growth seemed to be slowing down significantly, draconian anti-COVID measures remained in place, and state intervention (or interference if we are being less generous) was evident in various sectors. Tencent, and by extension Naspers/Prosus, looked like a dicey bet. Investors and portfolio managers who backed their research and understanding of market dynamics rode out the market volatility.
Toward the latter part of 2022, the ability to manage and curtail the pack animal in many of us started to pay off. The Chinese economy gradually opened, China eased its anti-COVID measures, and it became clear that a booming local population was still an essential driving force keeping the growth engine chugging. Naspers’s share price, between 25 March 2022 and 24 March 2023, had more than doubled. To reiterate, timing the market is near-impossible, but this example does illustrate that there can be an opportunity in volatility.
If we understand our risk appetite, our investment horizon, and our required returns, we can see market volatility as an opportunity, provided we avoid knee-jerk reactions. Another way to temper our aversion to volatility is by ensuring that we are surrounded by teams (or groups, in the broader context) that can challenge our initial gut reaction. This enables us to take a more measured view, perhaps taking the time to do more research. Of course, having a scaffolding that combats our biases, not only includes having a knowledgeable and experienced team, but also extends to having a thorough, well-researched, and repeatable process. We need to acknowledge our herd instinct and manage it appropriately in all aspects (but especially when it comes to investing). This allows us, despite feeling like we are on a rollercoaster, to manage volatility and have an edge over our peers. In these ways, we can avoid being lemmings.
