In the last three editions of TimeWise, we explored some common human behaviours that can significantly undermine our ability to build wealth: Overconfidence, fear of missing out and loss aversion.
In part four of our five-part behavioural finance series, we will turn our attention to a phenomenon called herding or herd mentality bias.
Herding, in behavioural finance, refers to the tendency for individuals to follow the decisions of others, regardless of their own personal beliefs or preferences. It is often seen as a cognitive shortcut used to reduce uncertainty and the potential for decision-making errors. It is typically based on the assumption that others have already done the appropriate research before making their decision so there is no need to re-do that research – one can simply copy what the others have done.
One of the risks of herding is that a relatively small number of people deciding to do something can lead to a cascading of imitative behaviour amongst a larger group of people. In this sense, herding can be seen as a form of groupthink, in which conformity takes precedence over critical evaluation of evidence. At scale, herding can lead to asset bubbles in financial and other markets as well as panic buying and panic selling.
Recent examples include the late 1990s tech stock bubble where herding amongst investors led to extremely high and unrealistic valuations for many tech companies, despite the fact that many of them had no proven business model or even revenue streams. But herding is not a recent phenomenon – there was a famous example in Holland during the 1600s where a tulip bulb market bubble formed. At the market’s peak, the rarest tulip bulbs traded for as much as six times the average person’s annual salary.
At scale, herding can lead to asset bubbles in financial and other markets as well as panic buying and panic selling.
Herding is not a recent phenomenon – there was a famous example in Holland during the 1600s where a tulip bulb market bubble formed. At the market’s peak, the rarest tulip bulbs traded for as much as six times the average person’s annual salary.
Don’t feel bad if you’ve fallen victim to herding in some way in the past – it’s not your fault. We’re hard-wired to herd. Going against the crowd is painful emotionally and psychologically for most of us. It can be downright scary to go against the crowd – how foolish am I going to look if I do the opposite of what everyone else is doing, and I’m wrong and they’re right?! We’re reminded of a question our mothers used to ask: If all of your friends jumped off a bridge, would you jump, too? Herd mentality bias tells us the likelihood is high.
Herding can also occur in social settings, where individuals may conform to group norms in order to fit in or be accepted. This can lead to group polarization, where individuals become more extreme in their beliefs and attitudes when surrounded by likeminded people. This can create an echo chamber effect, where dissenting opinions are silenced or ignored, and groupthink becomes the norm. There certainly seems to be many examples of this in contemporary society.
To be fair, herding does not always have a negative outcome. Herding can be a useful mechanism for coordinating behaviour in situations where there is limited time or information available. For example, in emergency situations, individuals may rely on the actions of others as a cue for what to do next. In these cases, herding can help to promote a collective response that is more effective than individual decision-making.
Nonetheless, in a financial and investment context, following the herd rather than making well-thought-out decisions for yourself, may save you time but more often than not it will not save (or make) you money in the long run.
Article from the Spring/Summer 2023 issue of TimeWise.
