Executive Summary
A key value proposition for financial advisors is helping clients avoid common behavioral biases that can lead to suboptimal investment decisions. Even people who are normally rational decision-makers can be prone to fear, greed, and overconfidence, and the persistence of market bubbles where investors chase whatever company or sector is all the rage at the time (and often get stuck with losses when the bubble pops) shows that herd mentality in investing is as prevalent as ever. Which often leads to advisors counseling their clients to stay diversified and stick with a disciplined investment strategy to optimize their risk and return over the long term.
But even today, despite the evidence we have about our tendencies to make irrational choices, people still often fall prey to herd mentality in their investment decisions, as demonstrated by modern-day bubbles around meme stocks and cryptocurrencies. Even professional investors such as venture capitalists aren't immune either, with the rise and fall of companies like WeWork and Theranos showing that sophisticated investors can be enticed to abandon a disciplined approach by a sales pitch that's too good to be true. In fact, as more and more technology proliferates, with much of it promising to have a worldwide and life-changing impact, the temptation to chase the next big thing may grow even stronger.
However, it isn't just individual companies or speculative assets like Bitcoin that can be prone to bubbles. When a new technology or product is introduced that has the potential to reach a huge new market, investors tend to bet on many (or even all) of the companies that provide the technology as if they will each become the dominant player in that market. And because every company can't possibly become a winner (since they're competing with each other, and one company's success will necessarily come at the other's expense), this tends to result in the entire industry becoming overvalued. Investors' enthusiasm tends to feed on itself, resulting in increasingly unrealistic valuations, until suddenly reality comes into focus, and prices drop for all companies in the industry – often wiping out some companies and creating severe losses even in the ones that do survive.
There tend to be 4 main signs of this type of "Big Market Delusion", which have been present in market bubbles ranging from the 1990s dot-com boom to the 2000s digital advertising market to the 2010s cannabis industry. First, there is a story of a vast potential market for a new technology or product; second, investors and entrepreneurs tend to ignore the possibility that competition will squeeze profits for existing companies and reduce expectations for future revenues; third, companies focus overwhelmingly on growth in users or revenue as the primary metric rather than profitability; and finally, the valuations for these companies grow with no connection to their underlying fundamentals. And though it may not be possible to time exactly when a big market bubble will burst, these signs make it highly likely that a correction will happen eventually.
The key point is that when an investor bets on a new technology or industry becoming huge based on the size of its potential market, even 'diversifying' by investing in multiple companies within that industry won't necessarily protect them from losses, because when the entire industry becomes overvalued, the resulting correction is likely to affect everyone. The simple way to avoid getting caught up in big market delusions is by remaining broadly diversified across markets – and for advisors, the lessons learned from previous examples of big market delusions can help guide clients on avoiding the next one!
Sober nations have all at once become desperate gamblers, and risked almost their existence upon the turn of a piece of paper. To trace the history of the most prominent of these delusions is the object of the present pages. Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.
— Charles MacKay, Extraordinary Popular Delusions and the Madness of Crowds, 1841
Psychologists have long known that individuals allow themselves to be influenced by the herd mentality, or the "madness of crowds", as the English novelist and playwright Charles MacKay described it back in the 1840s. The herd mentality may be defined as a desire to be like others, to be part of the 'action' or 'scene'. This mentality manifests itself in the fashion world where, like the length of a skirt or the width of a tie, fashions seem to come in and go out of favor for no apparent reason.
In the book The Works of Henry Fielding, the author elaborates on MacKay's perspective by putting it this way:
Fashion is the great governor of this world; it presides not only in matters of dress and amusement, but in law, physics, politics, religion, and all other things of the gravest kind; indeed, the wisest of men would be puzzled to give any better reason why particular forms in all these have been at certain times universally received, and at other times universally rejected, than that they were in or out of fashion.
Unfortunately, when it comes to investing, people who are usually rational decision-makers can be influenced by a herd mentality. The potential for large financial rewards plays on the human emotions of greed and envy, as well as the Fear Of Missing Out (FOMO). In investing, as in fashion, fluctuations in attitudes often spread widely without any apparent logic.
But whereas changing the length of a skirt or the width of a tie won't affect a person's net worth in any appreciable manner, allowing investment decisions to be influenced by the madness of crowds can have a devastating impact on someone's financial statement.
Even professional investors can get caught up in the hype, as evidenced by the rise and fall of the co-working office space startup WeWork: As a private company, WeWork soared to a $47 billion valuation as institutional investors like SoftBank were drawn in by founder Adam Neumann's high-flown promises to revolutionize work and life. In reality, however, WeWork's sky-high valuation was nowhere near justified by its underlying business model, a fact laid bare when it filed for its IPO in 2019 – and by the time WeWork started trading publicly in 2021 (after aborting its initial IPO attempt), its market capitalization had sunk to $9.5 billion, while as of this writing, it now comes in at under $3 billion.
For financial advisors, a key part of the value proposition of their service is often in helping clients avoid the irrational behavior that has historically plagued investors. The idea that humans' cognitive biases and propensity for emotional decision-making is widespread (with books like Richard Thaler and Cass Sunstein's Nudge, Nassim Taleb's The Black Swan, and Daniel Kahneman's Thinking, Fast and Slow having each become bestsellers while discussing the psychology that leads to irrational choices), and there are reams of research showing that broadly diversified investments in low-fee index funds beats making concentrated bets in individual companies or sectors for the vast majority of investors.
Despite all the awareness we have of our tendency to make emotional decisions and irrational choices, people are still likely to fall prey to herd mentality in their investment decisions. The pandemic-era bubbles around meme stocks and cryptocurrency are among the most notable recent examples. It's as important today as ever for advisors to understand the reasons that humans get wrapped up in herd thinking so they can help their clients avoid the mistakes that come along with it.
Why do herd-mentality-driven bubbles persist? One reason could be that investing, especially in speculative assets, has become much more of a social activity over the past 25 years. The dramatic growth of investment clubs and the proliferation of internet chat boards (such as Reddit) is supporting evidence. Today, investors often spend many of their nonworking hours online – reading, discussing, or simply gossiping about their investments (and of course, they discuss their successes with far greater frequency than they do their losses, contrary to the cliche that misery loves company).
Influenced by the herd, investors may start betting huge sums on investments they know little or nothing about or would not have previously considered if their social networks weren't all talking about it. If a particular madness lasts long enough, even conservative investors may abandon long-held beliefs, feeling they have missed out on what the crowd deems 'easy money' or a sure thing. They forget basic principles such as risk and reward and the value of diversification.
Another way of describing this phenomenon is the 'Uncle Jim syndrome': As in, "If Uncle Jim can make all that money owning Google, Amazon, Netflix, and Tesla, why can't I? I'm at least as smart as he is." Never mind all of the duds that Uncle Jim has owned that didn't pan out and that he doesn't ever mention.
While it doesn't happen often, perhaps once every generation or so (just long enough for people to forget the last bubble and for a new generation of investors to come of age), bubbles seem to appear with regularity. For example, in the 1960s, we had a 'tronics' bubble, when any stock with 'tronics' as a suffix soared to heights never imagined. It was followed by the Nifty Fifty bubble in the 1970s, the biotech bubble in the 1980s, the dot-com bubble in the 1990s, and the housing bubble in the 2000s.
There have been enough manias that several wonderful books have been written on the subject, including Robert Shiller's Irrational Exuberance, Edward Chancellor's Devil Take the Hindmost, and Charles MacKay's Extraordinary Popular Delusions and the Madness of Crowds. MacKay's book is particularly noteworthy because it was written in 1841 – proving that human behavior, around fashion or investing or anything else, changes remarkably little, even across different eras in history.
Since fashions affect social behavior, is it not logical to believe that they affect investment behavior (which, as mentioned above, is often a social activity for the people doing it) as well? In his book, Shiller makes the strong case that mass psychology may, at times, be the dominant cause of stock price movements. While the market is very rational over the long term, for short periods, it can become quite irrational. The madness of crowds takes over, and a new 'conventional wisdom' is quickly formed.
MacKay put it this way: "Every age has its peculiar folly: some scheme, project, or fantasy into which it plunges, spurred on by the love of gain, the necessity of excitement, or the force of imitation." Sir Isaac Newton was reported to have said about the investment mania of his day, the South Seas Company, "I can calculate the motions of heavenly bodies, but not the madness of people."
Shiller argued that "anyone taken as an individual is tolerably sensible and reasonable – as a member of a crowd, he at once becomes a blockhead." En masse, blockheads can play a major role in the stock market. What are known as positive feedback loops lead to self-fulfilling prophecies – in the short term, buying attracts more buying, and prices go up simply because they are going up.
Buoyed by rising prices, investors become more confident, enticing more money into the market – helping to explain the well-documented momentum factor. But like a Ponzi scheme, the strategy works until it doesn't. Herding can create bubbles and the devastating impact that unfortunately results from the bursting of those bubbles.
How "Big Market Delusions" Cause Entire Industries To Be Overvalued
While manias can develop in many different ways, there's one phenomenon, known as the "Big Market Delusion", that is worth highlighting in particular because of its ongoing relevance in today's world of new and rapidly proliferating technologies.
The Big Market Delusion is a concept developed by Bradford Cornell and Aswath Damodaran in their December 2019 paper The Big Market Delusion: Valuation and Investment Implications, in which they examined how the "big market promise" affects business formation and financing. Their key insight was how, when a new product or technology is introduced with the potential for widespread adoption, investors' enthusiasm about the prospects for dramatic growth – based solely on the size of the technology's potential market – leads to overconfidence and the collective overpricing of all companies involved with the technology in question, even though they may be in direct competition with one another and with established firms in the industry.
In such "big market" bubbles, it's not uncommon for each firm that serves the potential new market to be priced as if it were to be a major success story. The problem with this is that when every firm is priced as a winner, the aggregate value of all the firms in the industry exceeds any reasonable estimate of the value of the technology itself. In other words, the whole (i.e., the total potential business that can result from the big market in question) is exceeded by the sum of its parts (i.e., the individual companies serving that market) – a sure sign that some, if not all, of the companies are overpriced compared to their fundamental value.
The overpricing can persist because, compared to more established markets, the shares of emerging technology companies tend to be more thinly traded, less liquid, and more volatile, meaning that arbitrage opportunities are limited and short selling is costlier and more risky. And because companies at this stage often get acquired, an over-optimistic buyer of one company can distort the perceived value of other firms across the industry.
Eventually, however, the divergence between a company's price and the value that reflects a more realistic assessment of the earnings the big market can deliver leads to a correction – and over time, as data on actual sales and earnings become public, stock prices of most, if not all, of the companies in the "big market" decline.
Overconfidence Vs. Reality And The Promise Of Big Markets
Cornell and Damodaran begin their paper about the Big Market Delusion by noting the following:
There is nothing more exciting for a nascent business than the perceived presence of a big market for its products and services, and the allure is easy to understand. In the minds of entrepreneurs in these markets, big markets offer the promise of easily scalable revenues, which if coupled with profitability, can translate into large profits and high valuations.
However, while a big market may provide an opportunity for a business to succeed in addressing that untapped demand, it's by no means a guarantee that any one company will be successful in doing so. Rather, as Cornell and Damodaran note, for a business to succeed in a big market, "a whole host of other pieces have to fall into place":
- The company must be able to capture a reasonable share of that big market, a task that can be made difficult if the market is splintered, localized, or intensely competitive;
- The company has to be able to generate profits in that big market and create value from that growth, also a function of the firm's competitive advantages and market pricing constraints; and
- Once profitable, the company has to be able to keep out new entrants.
They concluded: "It is therefore dangerous to base an argument for investing in a company and assigning it high value based on enthusiasm for the size of the market that it serves, but that danger does not seem [to] stop analysts and investors from doing so."
The problem is that many entrepreneurs also see the same opportunity for success in big markets as investors do, and they are just as overconfident that they will be the ones to succeed. While data from the U.S. Bureau of Labor Statistics shows that 75% of all new businesses fail within the first 15 years, a study of about 3,000 entrepreneurs found that 81% believed that their chance of success was at least 70%, and 33% of the sample felt that success was guaranteed.
So, with numerous startup founders eager to take advantage of the opportunity of the big market, each of whom is able to find venture capital investors (who are also overconfident based on the size of the market and thus willing to provide funding), the result will be numerous competitors crowding into the marketplace, all drawn in by the big market's growth potential.
But because that competition also divides market share and introduces pricing pressure on the existing companies, as Cornell and Damoradan write, "while revenue growth in the aggregate may confirm that the market is big, the revenue growth at firms collectively will fall below expectations and operating margins will be lower than expected because each of the individual firms overestimated its own prospects."
Eventually, some or many of the participants may recognize the gap between reality and expectations, and competitors will either fold or consolidate. However, the authors further note that "despite the shortfall in the aggregate, there will be a few big winners and these big winners will fuel the cycle of enthusiasm for the next big market."
Cornell and Damodaran hypothesize that the size of the gap between perception and reality in a Big Market Delusion scenario is determined by 4 factors:
- The Degree of Overconfidence. The greater the overconfidence exhibited by entrepreneurs and investors in their own products and investment abilities, the greater the overpricing. While both groups are predisposed to overconfidence, overconfidence tends to increase with success in the market – the longer a market boom lasts in a business space, the larger the overpricing will tend to become.
- The Size of the Market. As the target market gets bigger, it is more likely to attract added entrants, and the collective overpricing will increase.
- The more uncertainty there is about business models and the ability to convert them into revenues, the more overconfidence will skew the numbers, leading to greater overpricing in the market.
- Winner-Take-All Markets. The overpricing will be greater in markets where there are global networking benefits (i.e., growth feeds on itself), and winners can walk away with dominant market shares.
The paper's authors also present 3 case studies to support their thesis:
- One where the process has almost fully played out (dot-com retail from the 1990s);
- One where it has been unfolding for a while (online advertising); and
- One where it is just beginning (the cannabis market).
In all 3 cases, the development of a new technology or product (e.g., public adoption of the World Wide Web in the 1990s, the rise of social media and search engines in the 2000s, and the gradual legalization of cannabis products in the last decade) led entrepreneurs and investors to recognize a huge potential market.
In each instance, enthusiasm for a crop of new and relatively unestablished startups led to pricing that, in the aggregate, far exceeded the actual potential market for each of the industries in question. And in each case, as expectations cooled and reality came into focus, prices receded across the board, wiping out the smaller and shakier players and causing even the comparatively successful and established firms to flirt with disaster.
Warning Signs Of A Big Market Delusion
In their Big Market Delusion research paper, Cornell and Damodaran warned investors that the cases discussed above are not unusual. On the contrary, numerous other industries may be near or in the midst of big market delusion behavior. The most prominent at the moment may be artificial intelligence, but Cornell and Damodaran also cited meatless meat, office leasing, rental housing, ridesharing, fintech (financial technology), and video streaming:
All these new markets that are predicted to be "huge" by the new companies entering these spaces. [sic] Furthermore, investors are bidding up prices dramatically based on the alleged potential of these new markets.
They warn investors to watch for these patterns:
- Big market stories. In every big market delusion, the shared feature is that markets are huge. For example, in the cannabis industry, the idea that many millions of American recreational cannabis users would soon be able to legally buy products (and would be willing to spend big dollars to do so) led to multibillion-dollar valuations for companies that had barely begun to earn revenue.
- Blindness to competition. When the big market delusion is in force, entrepreneurs, managers, and investors generally downplay existing competition, failing to factor in the reality that growth will have to be shared with both existing and potential new entrants. Again, in the cannabis industry, entrepreneurs and investors largely failed to take into account the influx of new competition that would materialize alongside legalization (not to mention the competition that already existed from the illegal sources that had once comprised the entire market).
- All about growth. When enthusiasm about growth is at its peak, companies focus on growth, often putting business models aside or even ignoring them completely. Technology companies, from dot-com stocks to social media sites to streaming video providers, have long prized user growth above all other metrics, with profitability almost an afterthought.
- Disconnect from fundamentals. The result of the factors above is that the pricing of companies throughout the industry becomes completely disconnected from the fundamentals. In nearly every case, the fundamental numbers like earnings, revenue, and book value were so low as to make the pricing multiples at which they traded effectively meaningless – and yet, because investors focused primarily on those multiples, they missed the disconnect and were satisfied so long as the number kept going up.
Notably, while the above characteristics were shared among most big market delusion cases, Cornell and Damodaran write:
There are also differences in how these markets correct. For instance, the dot com bubble hit a wall in March 2000 and burst in a few months, as public markets corrected first, followed by private markets. The online advertising run-up has moderated much more gradually over a few years, and if that trend continues, the correction in this market may be smooth enough that investors will not call it a correction. With cannabis stocks, the rise and fall were both precipitous, with the stocks tripling over a few months and losing that rise in the next few months. In all three cases, the most difficult variable to pinpoint is what caused the correction to occur at the time that it did.
In other words, while it may be possible to identify a big market delusion scenario as it is occurring and to predict that it will eventually result in a correction, it is harder to time exactly when the bubble will burst.
Cornell and Damodaran conclude:
The big market delusion is driven by bias in the selection of people who become entrepreneurs and venture capitalists. Overconfident in their own abilities, entrepreneurs and venture capitalists are naturally drawn to big markets which offer companies the possibility of huge valuations if they can effectively exploit them. And there are always examples of a few immense successes, like Amazon, to fuel the fire.
These factors lead to the big market delusion.
They go on to suggest that with most industries comprising a mix of public and private companies, the enthusiasm of venture capitalists bleeds over to individual investors and vice versa. But while venture funds typically have broad portfolios that can absorb many losses (while the substantial upside of hitting on just a few winners can make it worthwhile to do so), most individual investors don't have that luxury.
The point of diversification is so that only in the rarest circumstances will all of the assets in a portfolio go down at the same time – which is exactly what happens in a big market delusion scenario when prices start to correct. Even when owning all of the companies at once, a portfolio that is heavily concentrated in a sector or industry encountering a big market delusion will decline since it's the entire industry experiencing the correction, not just 1 or 2 companies.
For an in-depth example of an industry that may currently be experiencing its own big market delusion phenomenon, we can turn to Electric Vehicles (EVs).
Case Study Of A Big Market Delusion: Electric Vehicles (EVs)
2 recent papers have applied the concept of the big market delusion to the Electric Vehicles (EV) market. The first, Big Market Delusion: Electric Vehicles by Robert Arnott, Bradford Cornell, and Lillian Wu, was published by Research Affiliates in March of 2021; while Big Market Delusion: The Case of Electric Vehicle Stocks was published by Bradford Cornell, with coauthors Shaun Cornell and Andrew Cornell, in the August 2023 issue of The Journal of Investing.
In their study on EV stocks, Arnott et al. presented evidence that the EV market can be characterized as a prime example of a big market delusion. They began by citing the airline industry as an example:
The development of the airplane was one of the great technological innovations of the early 20th century. In the years that followed, affordable air travel and transport revolutionized the way people lived and interacted as well as altered global commerce and trade. Air transport became a huge business, but airlines did not necessarily provide a wealth bonanza for investors.
From the beginning, the air travel business has been capital intensive and highly competitive. During good times, new airlines emerged and drove down profits. During bad times, many less well-capitalized companies folded. Over the course of the last century, virtually every company in the business either failed or merged into a larger airline, most of which also collapsed.
They then noted that the airline industry has a lot in common with the EV industry.
EV Industry: A Lesson in the Making?
Both the airline and auto industries have historically been competitive, capital-intensive businesses, which have tended, on average, to trade at book-to-market ratios near or below 1.0. Is the change in the propulsion system from internal combustion engines to electric motors likely to have a pronounced impact on market competition or on the total industry valuation of the companies? Arnett et al. don't think so – neither the global market for automobiles nor the capital-intensive nature of their production seems likely to change as a result of the shift towards electric.
In fact, the EV industry has nearly the same market cap as traditional automakers despite having a small fraction of the revenue. Yet, as the authors note, while the value of the EV companies grew 618% over the 3-year period ending January 2021 (pushing their total market cap to $1.0 trillion, almost on par with the $1.1 trillion market cap of the traditional automakers), their sales remained "a tiny fraction of the revenues generated by the traditional automakers: 1 to 42 on average over the three-year period."
Arnott et al. next showed that given Tesla's market cap of $752 billion at the end of January 2021 (it exceeded $800 billion at the end of August 2023), Tesla accounted for about 75% of the total EV group's market value and 35% of the market value of the entire auto industry.
Such an immense market capitalization makes sense only if the expectation is that Tesla will come to dominate the entire auto industry, not just the EV market.
Such an achievement requires that both Tesla's brand and technology become so dominant that the company can earn profit margins that exceed those of Ferrari on a level of production exceeding that of Toyota. If that is the scenario reflected in Tesla's price, it should also be reflected in the falling valuations of its competitors, including competing EV specialists, whose market share will presumptively decline in favor of Tesla...
However, demonstrating that the EV market was showing signs of a big market delusion, the reverse was true. While Tesla's stock price was skyrocketing, the prices of competing EV firms were also doing so. In fact, the market value of each of the 8 EV makers more than doubled in the 12-month period ending January 2021. And "although the concurrent price increases of most conventional automakers could not be described as skyrocketing, they were rising handily, although a few did lose ground."
Arnott, Cornell, and Wu noted that the rise in prices of EV makers led to astronomical valuations. For example,
Nicola Motor, founded in 2015, with near zero revenues and no actual production to date, is priced at 22,000 times sales, and profits are, of course, nowhere in sight. Electra Meccanica, also founded in 2015, the first maker of the electric 3-wheeler, is priced at 600 times sales. Even new entrants XPeng and Li Auto are respectively priced at 47 times and 52 times sales, nearly twice the valuation multiple of Tesla. All of these companies are priced as if they are going to be huge winners, but they are competitors! They cannot all assume dominant market share in the years ahead!
Given their observations, the authors conclude that "today's electric vehicle industry is a classic example of the big market delusion", and summarize as follows:
The EV phenomenon will not change the fact that the auto industry will remain highly competitive and capital intensive, and not every company can be a winner. Further, it remains unclear how simply switching the means of auto propulsion will make the entire light EV market more profitable, an assumption the market is now currently making.
There are 2 additional signs of the big market delusion more recently. First, in August 2023, electric bus maker Proterra Inc., with 135 transit agency contracts and $309 million in revenue, filed for bankruptcy. In January 2021, Proterra was valued at $1.6 billion, including debt, in a merger deal with a blank-check firm. Second, as of September 25, 2023, Lordstown Motors, manufacturer of light-duty electric trucks, had a peak valuation of $5 billion in February 2021 after the company went public through a reverse merger with a Special Purpose Acquisition Company (SPAC), yet their market cap was just $64 million!
Advisor Takeaways
As researchers Bradford Cornell and Aswath Damodaran explained, big markets have a very special allure for investors, offering the potential of another Apple, Google, or Microsoft. After all, those firms successfully turned the promise of a big market into large and profitable businesses and rewarded investors who came along for the ride. These success stories happen just often enough – and are big enough when they do happen – to keep the hope alive for investors who want to get in early on the next big winner.
However, like buying a lottery ticket, the outsized profile of past winners can cause people to greatly overestimate their chances of picking the next one. And as the evidence above has shown, the potential of a big untapped market can distort peoples' perceptions even further, with overconfident investors pricing every firm serving that market as if they were going to be major winners despite there being no plausible likelihood of that happening.
Furthermore, even if an investor were to manage 'winning' the lottery by picking the eventual market leader in a new and disruptive industry, there's no guarantee that even that company wouldn't eventually be 'disrupted' itself.
In their paper, Arnott, Cornell, and Wu provide this example from the cell phone industry: In 2000, Palm, the maker of the then-ubiquitous Palm Pilot, was spun off by owner 3Com at a valuation larger than General Motors, and even larger than 3Com itself was before the spin-off. After only a few years, however, Palm was put out of business by Blackberry – which itself was soon on the ropes because of competition from Nokia. Nokia was already a major player in the mobile phone market, and it quickly adapted to the smartphone market with its Symbian OS. Nokia was the world's leading smartphone manufacturer in 2007, but it lost market share to Apple (after the introduction of the iPhone that year) and to Samsung in the following years. By 2020, Apple was the largest cell phone maker, and it remains the leader today.
The historical record provides us with many such examples of how, while market disruption often benefits society at large, the initial disruptors aren't always the ones to realize lasting success (and disruptors are often disrupted themselves in due course). So, for example, while Tesla may currently own the large majority of market share in EVs today, there's no guarantee that some other automaker won't come along to take its place, as Apple did to Blackberry and Nokia. And even Apple may not be immune to the same disruptions that befell investors in Palm, Blackberry, and Nokia.
The obvious takeaway for advisors, then, is to caution against investing in companies based on the size of the market they can potentially serve. This is particularly the case when the key patterns that characterize a big market delusion are present (big market stories, blindness to competition, overemphasis on growth, and a disconnect from fundamentals) – though, of course, having a general rule against taking any concentrated positions in individual companies can help protect against these and other idiosyncratic risks that can be mitigated through diversification.
Even though diversification is often an investor's friend, it's also important to be mindful of the limits of inadequate diversification in a big market delusion scenario. Recall that in a big market delusion, investors' overconfidence in the odds of each individual company becoming a winner causes the industry as a whole to become overvalued; in other words, the whole (the total market that can be served by a new technology or product) is worth less than the sum of its parts (the combined valuations of the companies trying to serve that market). When an entire industry is overvalued, the resulting correction in pricing is likely to affect not just 1 or 2 companies but most, if not all, of the firms across the industry.
What this means is that 'just' diversifying against single company risk (e.g., by investing in a sector-focused ETF or in multiple companies across an industry) won't necessarily protect against losses when the industry itself is overvalued. From an advisor's perspective, when a client is eager to invest in a company based on its potential to capture a big market, it may seem prudent to recommend an approach of investing across the industry to capture the perceived upside while minimizing the risk of concentration in a single company.
However, this approach leaves the client vulnerable to industry-wide corrections, which, as examples from the dot-com, online advertising, and cannabis industries show (all of which experienced industry-wide corrections after investors overvalued companies based on overconfidence in the size of the market they could serve), are all-too-common outcomes when the industry shows the signs of a big market delusion.
In other words, investors are best served by not trying to identify a sector or industry that will outperform and to avoid concentration or risk that is not rewarded commensurately with higher expected returns. All the evidence demonstrating that there is no persistence of outperformance by active managers beyond what would be expected by normal random variation should be sufficient to convince investors to avoid the game of individual stock and/or sector selection. If sophisticated institutional investors haven't been able to succeed (and indeed have been shown to be particularly vulnerable to falling into the trap of big market delusions), only overconfidence would seem to explain why individual investors believe they can do so.
Overconfidence is an all-too-human trait. In fact, Nobel Prize-winning economist Daniel Kahneman called overconfidence 'the most significant of the cognitive biases'. Given the odds against creating a successful business (about 4:1), one could argue that to be an entrepreneur, or a venture capitalist for that matter, you have to be overconfident! And overconfidence seems to be the most important ingredient for the development of a big market delusion.
The key takeaway is to avoid getting caught up in big market delusions, as recognizing and avoiding them would save investors a lot of grief. The simple way to do that is to avoid making any sector bets and to avoid the idiosyncratic risks of individual companies. Instead, invest in highly diversified broad market indices or factor-based funds highly diversified by industry. Forewarned is forearmed.
Larry Swedroe is head of financial and economic research for Buckingham Wealth Partners, collectively Buckingham Strategic Wealth, LLC and Buckingham Strategic Partners, LLC.
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