The stock market is a bee hive. Hundreds of brokers buzz around Wall Street from 9 AM to 5 PM issuing the buy and sell orders that make and break companies worth billions. Like bees, not every member of the stock trading machine acts on an original thought. An insight grasped by a single trader about an under-valued stock catches the interest of a wandering eye, causing a second trader to copy the initial buy order. And that’s how the Bandwagon Effect kicks off.
This article is the fourth in a series of Stocks to Trade articles describing the cognitive biases that have led brokers astray in the past.
Some of these constraints tie an investor’s confidence to the success or failure of a previous endeavor. Others speed up a traders’ hand, preventing them from gathering enough information to make a smart decision.
Following the lead of television gurus, high-profile Twitter traders and other self-proclaimed experts could lead to premature transactions as well.
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Suppose Wall Street forums, renowned brokers and your own best friend claim the markets are headed for a crash. Your analysis shows no such impending apocalypse, however. Instead of trusting your own analysis – which shows high market growth potential in the short and medium-terms, at least – you sell all the stocks in which you held a long position. The second-guessing cost you thousands, you realize two weeks later, as the same personalities unabashedly make new predictions after the markets belied their previous forecasts.
Truly skilled traders are few and far between. None spends time thinking about the herd, because unique success stems from a drive to think independently – to distill nuance from noise. They do not have a constant stream of external market analysis flowing into their ears as they conduct their own tests on a general financial analysis software.
They also do not fall victim to market bubbles, which occur precisely when thousands of traders hit the buy button in a short period of time, causing the asset’s value to shoot up in accordance with demand. The price reaches its peak when the buy market becomes saturated, no one is willing to buy any more of the asset and then it collapses in value – costing investors millions.
Tales of Wall Street bubbles themselves flood American financial history. A bubble collapse preceded the Great Depression of the 1930s. The decade prior had seen the rise of radio, automobile and aviation technologies, which quickly became a part of every deep-pocketed investor’s portfolio.
A similar phenomenon happened in the 1990s, when the dot-com bubble ravaged markets right after the internet connected people all over the world. Speculation regarding the long-term development of the World Wide Web caused an investment fever that set Silicon Valley ablaze. Companies with no business plan, but still espousing a “net” or “com” suffix on their official name, gained access to millions of dollars, without clear direction on how to use the capital. Firms claiming to be operating online failed left and right as a result. To recover the losses, the nation’s top engineering minds began to use their talents to attract the maximum possible number of ad-clicks. That is when e-commerce got its real start.
“Bandwagon” literally means a wagon that carries a band across town. The term dates back to the 19th century, when entertainer Dan Rice traveled cross country to support presidential nominee Zachary Taylor, inviting Americans to jump on his bandwagon and vote for the Whig candidate in the 1848 elections. The tactic worked in Taylor’s favor then, but since then it’s become a symbol of the masses supporting a person or because that seems popular, even if it goes against common sense or shared principles.
To avoid this bias, make sure you are not being unduly influenced by people with flashy titles that mean nothing. Make your own predictions, and know the logic behind them. Then turn on the television, log on to your forum of choice or open your mind to the Twittersphere.
Don’t get this wrong: your predictions will not always be correct. It’s worth listening to other perspectives, but make sure the techniques used by the person on the other side of the screen are sound. Celebrity stocks, like those picked out by Oprah Winfrey, George Clooney, or other stars who otherwise show no interest in Wall Street trading, should be taken with a grain of salt. Think: Why would they pick now to drop their knowledge? Do they have a personal stake in the company? Is it a PR stunt of another kind at play here? Star dust has captivating qualities, but avoiding it is essential to preserving the integrity of your portfolio.
With regards to initial public offerings, a strong publicity campaign or a mass-market company can cause stock prices to reach for the sky once shares become available for purchase. The overabundant enthusiasm will fade quickly, exposing the stock’s true value. That is when you should decide whether or not to buy in to the newly-public venture.
More than anything else, this bias is about knowing yourself. What outcomes are you seeking from your trading? Where does your ideal buy and sell price stand relative to your funds and desired profit margins? How strongly do you believe in your trading abilities?
Answer those questions, and you won’t ever be caught playing Simon Says with your long or short plays.
Bottom line? Don’t sleepwalk through life, as Socrates would advise us. If you’re on the ‘band wagon’, you’re sleeping through life and allowing others to influence your thoughts. Wake up, and trade—for real.
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