Tuesday, July 21, 2009

Know Your Biases: Bandwagon Effect

It takes only a bit of time in the stock market before the frequent disconnect between fundamentals and stock price movements become apparent. There's always a temptation to try to outguess which stocks are going to move and which aren't, using as the basis the companies' financials and combining them with news releases. Those who know about the efficient-market hypothesis should recognize it, in back-woods form, in that desire.

I can say from experience, though, that anyone who tries it is bound to get swamped by cognitive dissonance. Often, the number of contradictory ideas become several or many. As a result of the consequent confusion, a value investor often returns to the fundamentals and gives up on the idea. The most that can be gained from such an exercise, even when confining oneself to real value stocks, is skill in trading. Any market sense acquired from this attempt is a trader's sense.

Doing so does lead to confrontation head-on with the bandwagon effect. Regardless of the long-term futility of "trading value," another useful byproduct of such an exercise is confronting, and ideally besting, that cognitive bias. I offer the opinion that it's best done with a mock account.

According to Wikipedia, the "Bandwagon effect...is the observation that people often do and believe things because many other people do and believe the same things." It surfaces all the time in the market place, including in areas far removed from speculative frenzy.

Why is stock ABC going up while stock XYZ languishes? The question is puzzling when ABC and XYZ are about the same value, but poignant when XYZ is the better value. It's normal to search for a news item or other piece of information explaining why, but in many cases there's none. The bandwagon effect seems to start out of nowhere, run its mysterious course, and then stop. It's always explainable, if only through the word "anticipating," but it's never predictable.

The kind of bandwagon effect I just pointed to is a relatively benign one. It's caused by a value stock moving from out-of-favor to more favorable status. Value investors, except for those solely in it for the dividends, actually count on the bandwagon effect acting on an undervalued value stock* to bring it up to fair value.

There's a more baleful version of the bandwagon effect, which acts more like a plague on value investors. It visits when the selling bandwagon gets rolling, to the detriment of a stock that good analysis has shown to be good value. I can say that a value investor has not earned his or her spurs until s/he has sweated over an undervalued stock that's become even more undervalued in a hurry. In a lot of cases, the stock has gone on sale...but we're all susceptible to the bandwagon effect when we're anxious. Averaging down does take some guts in many situations; reviewing the fundamentals to see if the value's changed does take a dollop of forbearance...even if it's easier to descend into contrarian cynicism and say, "to hell with it. The stock's being driven down by the mob; nothing more." Reacting in this way does avoid conformism, but it's still reacting.

There are always those value traps...

*: That phrase isn't redundant. Other kinds of stocks can be undervalued too, particularly ones that show stronger fundamentals than were previously evident. The most speculative example I can think of would be a mining-exploration penny stock that scores great drilling results on a previously unremarkable property. I don't think anyone can call an exploration penny stock, however undervalued in retrospect, a "value stock." The same demur applies to biotech research firms who discover a profitable compound, or who get favorable FCC results, or otherwise show that their prospects were generally underrated.

No comments:

Post a Comment