Number three in the series on Investing Biases: Carole explains why, although part of our survival mechanism, following the herd can be dangerous.
Better than a herd of animals
What is the difference between a herd and a tribe? I think we see it is an insult to be labelled as one of a herd but a compliment to be part of a tribe. Herds are made of animals but tribes are made of people and – in that uniquely human way we have of putting ourselves at the centre of absolutely everything – we like to think we are better than herds of animals.
Following the herd implies a blind following, a submission of self and a suspension of judgment or opinion. Sheep-like, we will go with the flow at times when we fear that standing still – or, worse, standing out – won’t do us any good. Sometimes we are right to do just that – lining up dutifully to get our COVID-19 vaccines when they become available is a case in point. Less so other times, like if we were to bet the house on SouthSeaTulipManiaDotCom (see what I did there?) for no other reason than that everyone else is betting theirs – even though it has no prospect of earning us a profit for at least 20 years.
Scattering pound notes to the winds
I clearly remember hearing about that most famous of examples of the herding bias – the South Sea bubble – from the mouth of my history teacher. She told us we were to imagine a bubble that had so much air pumped into it that it burst. While this image explained perfectly what happens when you put too much air into a bubble, I struggled to apply it to the investment situation. All I could see in my head was a sort of giant hot air balloon, which, upon explosion, scattered pound notes (remember those?) to the four winds. No one bothered to explain what actually happened to the money.
When you invest in shares you get part ownership of a company that sells – or hopes to sell – goods or services. That part ownership gives you the right to a share in the profit that the company makes. In addition, if the company becomes successful and grows so that it makes even more profit, someone else will want to buy your shares from you at a higher price than you paid for them. And if two or more people want to buy your shares this will push the price up a bit more, like in an auction.
The bubble bursts and the price tumbles
However, when the herd instinct kicks in (aka FOMO), and you have hundreds or thousands of people wanting to buy your shares, there comes a point where the price goes so high that even the most sheep-like of sheep can see that the company will never be able to make enough profit to make the investment worthwhile. It is at this point that the bubble bursts because, suddenly, everyone who bought their shares while the price was riding high starts to feel a tad foolish and wants to sell. Trouble is, no one wants to buy anymore because the price is too high. So the share price tumbles and your investment is worth less than you paid for it.
Scarpering down the hillside…
For all the sophistication and complicatedness that has grown around financial stock markets, they can often seem little more than an embodiment of the herd instinct. Even the most cursory of glances at the finance page of your chosen news source in the past couple of weeks would show you just how easily the market can change direction. Commentators might talk of how an event can “spook” the market: think of a wolf stumbling into a herd of sheep, causing them all to scarper down the hillside, one after the other.
…then climbing back up again
Then, once the sheep are at the bottom, the wolf is out of sight and so the sheep might gain enough confidence to climb back up again – sometimes to find that the pesky wolf was hiding behind a gorse bush all along. On the day that Pfizer announced it had a vaccine that worked in over 90% of people, markets soared by over 5%, only to fall back again in the ensuing days because of (as one commentator put it) “worries about the economic impact of the pandemic”. Sorry, Markets, did no one tell you about that? Or did you just forget?
Seeking comfort in the crowd
Just as with the sheep, our herding instinct can be pretty strong at times – especially when we feel uncomfortable or lacking in confidence about our decisions. We see this in teenagers a lot: fitting in and being accepted as part of the herd is a matter of survival – even if the mode du jour is to stand out as an individual, that is still the direction in which the herd is travelling and so everyone must conform to the new non-conformity (if you get my drift).
We seek comfort in following the crowd and we fear being left behind. New or inexperienced investors can often fall prey to the herding bias because they don’t really want to take responsibility for their decisions. Or, more likely, because they went into an investment without having a good understanding of the way that markets roll.
Not really investing
For risk-takers and gamblers the rolling around can make markets an exciting means of making and losing money: by trading frequently on a short timeframe to take advantage of the herd of sheep scrambling up and down the hillside. But this is not really investing. Investing in shares for the long term means backing companies whose profits you think are going to grow. And for most people with modest means and scant expertise, it means entrusting investment professionals to pool your money with other investors and make those decisions on your behalf.
Losing everything when the wheels buckle
When someone has been a ‘saver’ all their life, becoming an investor is a big step. When I have spoken to women about investing who are self-confessed-risk-averse savers, their initial reaction is often to close it down as a ‘no-go’ area. I think this is an attitude that is maybe fuelled by what we see happening when everyone follows the herd: we fix in our minds the tales of investors who ‘lost everything’ when the wheels on the bandwagon they had jumped on buckled under them. Less newsworthy are the tales of people who have invested in funds that have a good spread across different types of investments with a long-term horizon that means they can sit tight through short-term wobbles until the markets calm down a bit.
Herding might trip you up
As with all the behaviours – or ‘biases’ – that might trip an investor up, it’s a good idea to keep an eye out for a tendency towards herding. Remember, we usually follow the crowd when we don’t know where to go ourselves or when we are fearful of missing out, both of which might indicate that some expert help is needed.
Bears, Bulls and Sheep
And finally… if you like animals, here’s some investment-speak to keep in mind: ‘Bears’ are generally pessimistic about where markets are headed while ‘Bulls’ are generally optimistic about where markets are headed. And sheep? Well, they will just follow the herd.
26 November 2020
Talking Finances is a trading name of Talking Finances Ltd. Talking Finances Ltd is an appointed representative of Beaufort Financial Planning Limited, Kingsgate, 62 High Street, Redhill, Surrey, RH1 1SH, which is authorised and regulated by the Financial Conduct Authority, FCA Registration No. 583233
All opinions are those of Carole Haswell and do not constitute financial advice