Herd mentality and other investor biases to avoid
This content is for information purposes only and should not be taken as financial advice. Every effort has been made to ensure the information is correct and up-to-date at the time of writing. For personalised and regulated advice regarding your situation, please consult an independent financial adviser here at Smith & Pinching in Norwich, Lowestoft and Eaton. The Financial Conduct Authority does not regulate taxation advice, estate planning or inheritance tax planning.
Fear of missing out (“FOMO”) is a deeply ingrained human trait which is difficult to overcome. When we see a large crowd flocking towards something, we instinctively want to follow. In fact, there have been some funny social experiments showing British people lining up for queues in public, even if they do not know what they are for!
As an investor, however, the effects of this “herd mentality” can be less amusing. Perhaps the investment crowd flocks towards a “hot stock” which turns out to be a failure. The result can be negative returns and demoralising losses. Below, our Norwich financial planners wanted to explain how this common investor bias works – offering ideas to mitigate it.
We hope these insights are useful to you. If you want to discuss your strategy with us, please get in touch to arrange a meeting with a financial adviser:
01603 789966
[email protected]
Please note that the value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested’.
What is herd mentality?
We need to remember that human beings, just like other creatures, have a long evolutionary history. Much of our psychology emerged in the wilderness, surrounded by predators and harsh elements. To survive, humans needed to band together. To make a society work, even a little one like a clan, people need to align their beliefs, behaviours and attitudes – often at the cost of individual judgment.
This dynamic kept our species alive for hundreds of thousands of years as human civilisation emerged. However, in the 21st century, herd mentality is arguably less useful than it was in our primitive past. Advances in modern technology, particularly social media, have been difficult for us to adapt to.
Some studies have suggested that humans may not be able to cope with Facebook since we evolved to send social signals in small groups. Social platforms, by contrast, allow us to send out “in-group” signals to hundreds, thousands or millions of people. The resulting “likes” can create a dopamine hit in our brains, leading to a craving for more.
Within the investing world, herd mentality manifests somewhat differently. Whilst social media perhaps lends itself more to “virtue signalling”, investors may find themselves compelled to follow short-term investment trends and/or the actions of “celebrity investors”. An investor may notice large groups of investors flocking to an overvalued stock, failing to see the “bubble” which is about to pop. An example of this might be the Dot Com Bubble in the late 1990s, where the Nasdaq fell by 25% in one week after venture capital dried up.
How to guard against herd mentality
As an investor, you want to avoid any mental biases which may undermine your progress towards your financial goals – including herd mentality. All investors make mistakes, of course, and it is important to learn from them. However, wise investors do all they can to protect themselves from themselves!
Emotions are typically the main drivers of herd mentality. Fear and greed, in particular, can lead to herd mentality behaviour. Here, it helps to work with a financial adviser to keep your expectations grounded. It can be difficult to resist widespread claims that quick, double-digit investment returns are easily available. However, a professional can remind you that such “opportunities” are likely over-hyped and potential “bubble traps”.
Similarly, if many investors are warning that a certain stock or fund is about to imminently crash, a financial adviser can point you back to your long-term investment plan. They can remind you that you diversified your portfolio precisely to minimise the short-term damage of this potential outcome. They can demonstrate to you again why it is so difficult to “time the market” consistently and why it is better to spend “time in the market”. In particular, periods of low market prices can be opportunities to buy good investments at a discount!
Many investors call into herd mentality due to an information cascade. Here, investors base their decisions on investors who decided before them, and so forth. As the cascade lengthens, it seems more credible – reinforcing the herd behaviour. However, this clearly illustrates one reason why “might is not right” (large numbers of people can be wrong!). You can guard against this by working with a financial adviser to carefully analyse and select your assets in light of good information, rather than hearsay.
Confirmation bias can also feed into herd mentality. On social media platforms, “echo chambers” can be created where users only encounter opinions, statistics and news which reinforce their own preexisting beliefs. A similar dynamic can occur amongst groups of investors, leading to decisions based on incomplete or faulty information. Here, a financial adviser can be very valuable in presenting information, or investment “theses”, which you may not have considered and which may contradict your own. This process can lead to better choices since you can consider the counterarguments and rest assured that your chosen strategy stands up to them.
Invitation
If you are interested in discussing your own financial plan or investment strategy with us, please get in touch to arrange a meeting with a financial adviser:
01603 789966
[email protected]
