The bandwagon effect, or groupthink, describes gaining comfort in something because many other people do the same. After all, “there is safety in numbers” correct? This is a falsehood. But let’s separate bandwagon-ing, from conventional wisdom. There is value that is derived from conventional wisdom and there is not always a reward for contrarianism. The bias in groupthink is the falsehood that because others are doing it, there is value. I’m reminded of the gold rush. The boom and subsequent bust of the 1849 California Rush is a fantastic backdrop for this investment bias. Gold is valuable, is the conventional wisdom. Everyone is headed west to get the gold, is the bias. The belief that because many people are doing something causes the investor to discount the risk, misprice the upside and causes boom-bust cycles.
While there might not be a value centric rationale for the bandwagon bias, there is certainly momentum. So it is often hard to separate the return on an investment derived from the result of crowded momentum, from intrinsic value. One thing is certain, the belief that because other people are doing it causes a distortion in value. So there are two sides to this bias:
First – the belief that “everyone is doing it” can be something of a debate. The bias comes from the feeling that there is safety because others are doing something, this is a falsehood. There is plenty of anecdotal evidence that supports that common beliefs are not actually universally applied. Obviously, not everyone answered the call of the west and sought their fortunes. But enough did that caused those heading west to overlook and improperly discount the associated risks. These are all the prospectors that never made it to California at all.
Second – This is the belief that the reward delivered to everyone will be the same. That while they all took on the same risks, the value achieved was the same. We know this is not the case for investors. In the gold rush, this is the prospector that makes it to California but comes away disappointed, either because the stake doesn’t “pan out” at all or because it would have been more profitable to stay home.
In our view, to be a successful investor, you must be able to analyze and think independently of the crowd. Speculative bubbles are typically the result of groupthink and herd mentality. In the end, this bias is built on some conventional wisdom, and there is value to be had. But the Bandwagon Effect causes people artificially increase the likelihood of pay out, or discount the risk because of the presence of others doing the same. This is irrational and the cause of heartbreak.