Following the herd easy but not best way

By DAVID MOON, Moon Capital Management, LLC
April 11, 2010

When I was in the seventh grade, I asked my uncle why businessmen wore ties. He was a young banker in Birmingham, Alabama and it seemed to be another of the many mysteries to which my totemic hero would likely know the secret.

“Dave,” he explained with all of the deep mature wisdom of his 30 years, “it demonstrates a willingness to conform to the accepted practices of a given profession.”

And all that time I thought it was simply because everyone was afraid to look different than anyone else.

You’ve likely read that after the fear of dying, man’s greatest fears include things like public speaking, being friendless or lifelong virginity. There is a single fear, however, that encompasses all of these phobias.

The fear of appearing different.

It’s the reason kids want to wear the same sneakers and middle-age men want to drive the same cars.

It’s also why investors flock to the same stocks and bankers march off cliffs making the same silly loans.

In the early 1990s I was on the investment committee of the trust department of a large regional bank. Surprisingly, our primary goal wasn’t to make money with our stock selections. Our success was measured by how closely our returns matched those of a collection of a thousand or so other managers.

So what did we do? We bought the same stocks as everyone else. We might have put a bit more in Home Depot and a little less in Walmart than the S&P 500 or the bank next door, but for the most part, we were simply marching in line with everyone else.

People incorrectly believe there is safety in numbers. There is only numbers in numbers.

Last month, a record $38 billion of new junk bonds were issued, beating the previous monthly record from November 2006. It doesn’t matter that the underlying dynamics precipitating the credit crisis in 2008 still exist. Once investors started rushing for the junk bond market, a crowd of followers did what they always do – they followed.

They were afraid. They were afraid someone else might make money, and they wouldn’t.

If they lose money, that’s ok, too – as long as everyone else does.

Herd thinking is no more prevalent today than 10 or 30 years ago. It’s just more obvious at inflection points.

Until it gets to a cliff, a herd can run along, blissfully unaware of any impending risks. That doesn’t mean that the risks aren’t real, or that the behavior isn’t dangerous until the herd reaches the cliff.

Cognitive fluency is a measure of how easy it is to think about something. People prefer things that are easy to think about rather than those that are hard. Cognitive fluency signals familiarity, providing decision-making shortcuts that allow us to spend our time on other things.

One of the most popular manifestations of cognitive fluency is simply ceding your decision-making to another person. You look at what they do and copy it. It’s what millions of 401(k) investors do every January when they receive their year-end statements.

And so do thousands of professional investors, bankers and brokers.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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