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Defying the Herd


Resisting groupthink may be the only way to avoid major losses.

Minyanville's Why Wall Street Will Never Be the SameEditor's Note: The following originally appeared on February 15, 2007 and, in light of current events, has been reprinted here for the benefit of the Minyanville community.

I hope you'll relate the following story to how markets work:

I arrived at the airport late last night. There'd been extremely bad weather, and many flights had been canceled - but my flight arrived right on time. As I descended the escalators, I could see the line for taxis was very long.

There were no taxis where there were ordinarily 50 or so queued up and waiting. The line was at least 100 people long, winding around the building as far as the eye could see. I quickly calculated that the last people in line might as well start walking - they'd still get there faster than they would by waiting for nothing.

But there they stood, nevertheless.

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I had been at this airport before. I had nothing to lose. I walked right past the line, took a 2-minute walk to the next terminal, and got a cab right away.

How does this little story relate to markets?

The people in line were thinking inductively, as almost all people do. They assume that the people ahead of them know what they're doing, and thus rely on them to do the "thinking" for them.

People are social animals, and have powerful instincts urging them to "get along" and "go with the flow." The fact that there were no cabs just didn't dawn on the last people in line…surely the people ahead "knew" that cabs were on the way. Every person in line must have been thinking the same thing. This is how compression (outsizing risk) and major market tops are formed: The last buyers -- the most buyers -- are buying just because everyone else is.

I was thinking deductively. There were no cabs. The line was very long. I had nothing to lose by going to the next terminal. This is how some investors avoid major losses, by eventually going against the crowd and reducing risk despite the masses.

By definition, major social change is driven by individuals who go against the crowd.

So the next time you feel that irresistible urge to get into something because everyone else is, please just stop and think for yourself. Think deductively: Put the facts together, as best you can, and draw some conclusions.

It very well may be that everyone else is right (inductive thinking and empirical evidence certainly have validity), but there are times when making inductive assumptions can be disastrous.

No positions in stocks mentioned.
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