Suppose you are on a trip to a big city. You are walking around with a loved one on your side and thinking of getting a quick bite. You walk along the pavement and discreetly glance at the restaurants along the way. Do you enter the one with no customer inside? Certainly not! You enter the one that seems to be doing brisk business.
I hear you wonder — what does this have to do with risk?
The herding mentality not only works for a group of people but on a single person as well. Say you get your coffee for free in your office. While walking there one day, you chance upon Starbucks (SBUX) selling coffee at outrageous prices (a simple medium cup costs 6 Sfr in Zurich). You reason that coffee selling at such exorbitant prices must be quite exquisite indeed. You enter and the aroma of expensive coffee beans, the free Wifi and the upscale atmosphere predisposes you towards liking what the shop has to offer. You try the coffee, like it better than your free cup in the office and move on. You still think that 6 Sfr is too much for a cup of coffee, but your wall against Starbucks coffee has lowered. Suddenly, 6 Sfr does not seem such a high sum after all. After chancing upon the shop a few more times — you don’t even think about the price. You decide that this is what you pay for Starbucks coffee now. It seems like a reasonable expense.
How did you go from someone with free coffee, to trying it once for 6 Sfr, to someone who buys it on autopilot?
Dan Ariely, the author of "Predictably Irrational," has a cute way to connect this to the herding behavior described above.
When we are considering if we should try something for the first time, it is like sampling a restaurant with no one inside. There is only a small chance of us going in. But we try it once, and the second time we "figuratively" see ourselves in the restaurant. Each visit increases the number of people we see in the restaurant (all of them are us at different points in time). We, in effect, have herded amongst ourselves.
Going from “no way!” to “just once” is an incredibly different task compared to going from “just once” to “just twice.” The first barrier is the hardest to break. Once you break it, you know the experience of the other side and you might be led into trying it again.
The same thing applies to investing, as well as gambling.
If you gamble once and win you are probably going to gamble again, even though you promised that you would not do it twice. If you win again, the chances of gambling the third time are even higher. You probably start considering yourself a lucky hand. This continues until you suffer a big loss or you come to your senses. After that, you probably gamble a lot less.
This is one of the reasons I did not get into J.C. Penney (JCP). Bill Ackman, who I respect quite a bit, is one of the investors and owns a significant amount of stock. Furthermore, since 2011 the price has see-sawed between $18 and $26, recently touching $14. Each time, the stock has recovered and each time, I have seen it climb out with a bit of a predictable and irrational “missed opportunity” feeling.
But I have never pulled the trigger. Even though I could have acquired call options, lowering the absolute amount of cash risk.
The reason, quite simply, was that I had not done satisfactory research myself. I read Science’s articles and have also read Ackman's thesis, but I have never gotten around to disabusing myself of the risks associated with putting my money on the line. If the stock tanks 50%, I will not know the head from the tail.
It will be no better if the stock is a winner. In fact, I will be worse off! If I lose, then I learn a lesson. If I don’t, then I might pay a higher price. I remember a folklore which my grandmother told me when I was small.
A man went to a barber. The barber was not great and he cut the man’s cheek. The man did not get angry. The wound was not huge and he let the barber finish his job. After the barber was done, the man gave him his wages plus a tip and went on his way. Next day, the barber tried the same thing on another and was severely beaten.