Herd Mentality Bias: How it affects your Investment Decision

23 Sep 2020  Read 2342 Views

Since their evolution, human beings have tried to remain in groups. We all want to belong to a group. But why? Why is it so important for us to fit into a certain group? 

This is because we are social animals, and we all need social acceptance. In times of uncertainty, we fear and let the herd guide us. Sure, the crowd's guidance can be an important crutch to lean upon, but what happens when we use it too often? Or when we are simply lazy to find our way of doing something or make a decision? 

The concept we are teasing out here is herd behavior, and we can simply define it as people doing what others do, instead of using their own conscience and knowledge to make decisions

Understanding herd mentality bias

We often see a group of people doing a certain thing in the same manner, and we tend to think that all of them cannot be wrong. There might be something they know which you might not be aware of. We start to base our decision on the assumptions that everyone else has done their research or know something that we don't know. This is known as herd behavior. But that's not always the case.

Consider the following example offered by economist Robert Shriller. Suppose two restaurants open next to each other: Restaurant A and Restaurant B. The very first customer sees two empty restaurants and chooses the one to eat at based only on their appearance. Let's say he chooses restaurant B. The second customer sees one person eating at restaurant B and an empty restaurant A.

Then, he will make his choice based on two things. First, the appearance of each restaurant, that's his information, and secondly, the fact that the first customer chooses restaurant B, which is external information. If the second customer chooses to go to restaurant B, then the third customer will see two people eating at restaurant A and an empty restaurant B. as people continue to join the crowd and prompt others to do the same. Eventually, each customer might end up at restaurant B, which might even be the poorer one as compared to restaurant A.

What has happened in the above example is that people have ignored their information. And that creates a distorted signal chain. We think that everyone has made an informed decision, and that decision appears to have value. But in reality, everyone's decision is based on the decisions made by others. And because of this, our decisions contain no real valuable information.

Impact of Herd Mentality behavior on your investments

As discussed above, herding means following a group, and this also applies to individual investments. Before investing their money, individuals take suggestions from different people, which may include parents, colleagues, friends, or maybe cousins. They try to understand how they are investing their money, and in what kind of instruments they invest and so on.

Stock markets get greatly affected by this herd mentality. These chains of behavior are sometimes called informational cascades. And they help us explain everything from market standard conformity, fads, booms, crashes, bull phase, bear phase, and so on.

For example, a group of people started buying the shares of a company, and the share price of that company starts rising. Some people look at these rising prices of the shares, and they also become a part of that group. Because they think that maybe the people who are buying these shares have some hidden information that they don't have, and they just try to follow the crowd. This builds a positive sentiment, and the markets get into the bullish phase.

Reasons of Herd Mentality Bias

There may be several reasons why people tend to follow some groups. Some of the reasons may be:

  • One of the most common reasons is psychological because we all are social animals, and we tend to stay in groups and move in groups. So it's a part of our instincts. 
  • Lack of individuality is also a reason why people rely on the decisions of others. In that case, there is no right or wrong for an individual; whatever it is, it's for the whole group.
  • People who are moving with a certain groupthink that the group has all the required and accurate knowledge for the investments

How can you avoid the Herd Mentality?

It is important to be aware of the natural tendency of herding. Consider if you want to buy a new smartphone. Your decision should be based on your needs and not on what everyone is buying. So how can you prevent yourself from herding? Below are some of the strategies you can use.

  • Think properly before you follow. Humans have a natural tendency to follow by default. This is when you stop thinking about your opinion and simply follow what others think is right. So next time, before following anybody, gather some knowledge and form your own opinion, in order to make a well-informed decision.
  • Take more time before you make decisions. Do not rush into any decisions. Spend some time analyzing the alternatives. 
  • Beware of the effects of making decisions under any stressful situation. When individuals are stressed, their ability to make decisions is not good, and there are greater chances of them following a herd.
  • Individuals should be willing to stand out. One should understand their own heart, their strengths, and weaknesses, and then make a decision.

In conclusion

It is worth remembering that people are afraid in times of uncertainty, and they tend to rely upon the herd to guide them. As the financial world collapsed in 2008 and uncertainty loomed above us all, there's no question that a herd mentality kicked in, and it probably played a major role in our decision making. 

Whether or not we are aware of it, our reliance upon the herd mostly influences our decisions to a very extent. Therefore it is important for individuals to be more aware of the information they are using to make decisions. 

The herd is not a synonym of bad; however, our over-reliance on herd prompts ignorance and distorts the information we use to make decisions. 

About the Author: Rashmeet Kaur | 17 Post(s)

Rashmeet Kaur is a certified investment advisor. She is aiming to be a financial analyst, and is the one who encourages reading and loves to explore economics and stocks. She loves to discover her own style while writing, and wants to live a creative and adventurous life. 

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