Herd Mentality in Investing
Herd Mentality, or the Bandwagon Effect, is one of the most prevalent phenomena that lead investors to different investing decisions. Investment decisions based on herd mentality are essentially based off the notion that “everyone else is doing it so why not.”
“Herdism,” as some might refer to it, is almost innate to human nature, not just in the context of financial markets, but throughout the spectrum of the human decision making process. In the investing world, retail investors are more likely to make decisions based on herd mentality than professional investors. However, professional investors do also fall prey to herd mentality, especially when there are some significant market events.
Why is herdism so popular?
First of all, there is comfort in crowds. Oftentimes, making a decision that is contrary to the crowd, is a very lonely place to be. Because of that, we will quite often neglect rational decision-making and just follow the crowd. Also, it is easier as it does not require you to spend any time researching or rationalising your decision. You can simply say you did something because your neighbour did it.
Herdism also gives an illusion of superiority. We tend to believe that if the masses subscribe to a particular decision, or way of life, or trend, that in itself justifies the decision and makes it the right way to do things. This is how a culture is gradually adorned; further, blending into what the crowd does lends the false illusion that it is the superior way of doing things. Being a standout can be quite a lonely place to be, wherein you have to put up with potentially being ridiculed or criticised by the masses.
Why does herdism not work in investing?
Most retail (or non-sophisticated) investors are emotional, trend investors. And unfortunately, a lot of retail investors buy into whatever glitters.
While this approach might work for buying household items or clothes shopping, it is quite hazardous when investing your hard earned cash. Herd mentality is what turns a small scam or “Ponzi” scheme into an international wild fire. Ponzi schemes count on herd mentality; people buying in because their neighbours, fellow church members and family have already bought into it.
Another reason herd mentality is dangerous to any investor, even if the herd is fanning flames for a legitimate, worthwhile investment, is that we have different risk appetites, investment objectives, investment horizons and risk capacities. Even the best investment in the world is not suitable for every investor out there. That is why there is a need to assess your personal financial goals before investing, so that your investment journey becomes aligned to these goals, meaning you are more likely to stay the journey and enjoy it while you are at it.
Lastly, the herd is seldom right, especially when it comes to timing decisions with regard to financial markets. The herd tends to buy emotionally; meaning they will buy at market highs and sell at market lows (thereby making a loss), because most investors are emotional investors and this impedes their potential to make rational investing decisions.
Be smart. Do your research. Make a note of your financial goals and stay away from the herd. An investment journey is a very personal journey.
This article was authored by Kgori Capital, a leading asset management firm.