Conventional wisdom suggests that the stock market is the destination of choice when it comes to laying the groundwork for future financial security and building personal wealth.
Since the rise of the 401(k) in the early 1980s, tens of millions of people have officially become stock market investors. Critics of the status quo worry that public awareness about the risks associated with stock investing needs to be improved.
Generally, I agree.
As such, I have been writing about some of the risks related to stock market investing that I feel people should know more about.
A few of the topics I have covered so far are,
- Formulating proper time frames for investing.
- Learning the risk of “sequence of returns.”
- Understanding the recurrence of stock market bubbles.
In this post, I focus on two issues that serve as underpinnings for the often futile pursuit of so-called “hot” stocks or other over-hyped trends in investing.
These are the “fallacy of composition” and the “bandwagon effect.”
Fallacy of Composition
Fallacy of composition refers to circumstances in which something that is true for a “part” may not necessarily be true for the “whole.”
For example, if one person stands up at a baseball game, he or she can get a better view. But, if everyone stands up, no one gets a better view.
Similarly, if only a few people bet on a particular horse at the racetrack, they can win big. But, if everyone bets on the same horse, the payoff will be small.
The same logic can be applied to investing.
A share of stock is essentially a claim on a company’s current or future earnings. If a company has a finite amount of earnings, its current stock price may represent a very good value for a certain population of investors.
But, if everyone were to buy the same stock, the fortunes could change.
First, the stampede of new demand would likely drive up the share price.
Sounds like good news, right?
Then again, maybe not…
- New investors buying the higher priced shares end up paying more for the same proportional share of the company’s overall earnings.
- If the company’s stock was formerly priced at $50 and paid a dividend of $3.00 per share, the yield would have been a respectable 6%.
- However, if demand drives the price of the stock to $100 and the dividend per share remains the same $3.00, the yield now becomes only 3%.
- New investors pay twice the original share price to get half as much yield in return.
- New investors also bear the risk that the stock price may fall due to the perception that shares have become overvalued.
The point is, what may have begun as a good deal for some, can end up becoming not nearly as good a deal after everyone (or a sizeable population) gets involved.
The Bandwagon Effect
The bandwagon effect refers to incidences where demand for a stock, commodity, or other investment is driven by social pressures such as, “everyone else is buying it.”
In such cases, people are moved to act because they feel societal pressure and/or the fear that if they do not act, they will miss out on an opportunity.
When combined, fallacy of composition and the bandwagon effect can serve to drive prices of stocks or other investments to remarkably high and unsustainable levels.
In general, the later a person arrives to the party, the more he will have to risk, the less he will stand to gain, and the greater the likelihood he will lose.
Mother knew best
It turns out, your Mom knew a little something about the about fallacy of composition and the bandwagon effect when she told you,
“Just because everyone else is doing something doesn’t mean that you should do it too.”
Sage advice for both life and for investing…
The next time you see the masses chasing the latest hot stock or other investment trend, exercise caution.
Just because everyone else appears to be getting involved, doesn’t necessarily mean it’s the right thing to do.
So what do you think?
- Have you ever seen a situation where what was good for a few was not necessarily good the whole?
- Do you believe the bandwagon effect has had an impact on current U.S. stock prices?
- Do you think stocks today are properly valued or out of line?
- Can the fallacy of composition be applied to participation in the market as a whole?