Why Investors Do The Crazy Things They Do – Concept 5 Herd Behavior

This is the fifth article in this series where I discussed a concept called behavioral finance. It’s a relatively new field that tries to combine behavioral psychology theory and economics and finance to explain why people make irrational financial decisions.

I’m no psychology expert, but researching and writing these articles have really opened my eyes. Some of these concepts I was totally aware of, while others were unknown but absolutely spot on!

We’ve discussed things like Hindsight Bias, Anchoring and the Gambler’s Fallacy just to name a few. This article will cover Herd Behavior.

Concept 5. Herd Behavior
In a nutshell, herd behavior is when individuals mimic the actions of a larger group, whether rational or not. Individually they may not make the same choices. One reason for this behavior: the need to conform. As human beings we need to fit in and be accepted. We don’t want to be the lone outcast. In addition, another reason for this behavior is the rationale that how can so many people be wrong if they are all doing it.

Herd behavior can be a very damaging strategy. Investors using a herd mentality constantly buy and sell investments looking for the next “hot” bet. Look at the most recent run up of oil and gold in recent years. I don’t know how many of my clients asked me about those two investments, but they have declined quite a bit recently. Was the herd right?

It’s very difficult to time buys and sells and be right over time. In fact, it’s nearly impossible. By the time the herd investor knows about a trend, the opportunity is probably over. This means that the poor herd investor is entering the game late and are more likely to lose money as those they did get in early exit and move on to another investment strategy.

How to Avoid the Herd Mentality
Recognized trends are hard to resist. It looks so obvious, like buying gold when it continued to go up day after day. Don’t you remember your parents saying, “If Johnny jumped off a bridge, would you jump off the bridge too?” Don’t make an investment because everyone else is, and certainly don’t make the investment because you are afraid of losing out. Keep in mind that the herd can make an investment overvalued by piling in at the wrong time.

My next topic will be Overconfidence. If you want this series of articles delivered to you automatically, click here for a free subscription and have them in your email inbox every Friday morning!