The recent market volatility has brought the subject of behavioral finance back into focus. There are biases inherent in the human mind that affect a person’s ability to make sound decisions, whether they are related to an investment portfolio or everyday life. Over the coming quarters, I’ll be looking at a number of these biases hopefully to help you better understand what they are and how to overcome them. Today, I’m starting with the Herding Bias.
I’ve referenced in the title of this article a saying I heard countless times growing up. For me, it was usually followed by “I know I raised you to be better than that”. My mother or father would utter these words in exasperation in response to my decision to go along with my friends on some little misadventure that got out of hand. While it was filed under “peer pressure” back then, it would be years before I fully understood what the Herding Bias was and how present it is in everyday life.
The principle behind the Herding Bias is that we fear being wrong alone more than we crave being right. As a result, people make choices based on what the consensus thinks. A lot of times, the Herding Bias is helpful. For example, if I’m deciding on which restaurant to order takeout from, I might check to see what the online reviews are. If it came down to two restaurants, one with a lot of great reviews and one with only a few, more than likely I’m going to choose the restaurant with the rave reviews. If a lot of people have gone out of their way to post glowing reviews online, it’s got to be good, right? In this example and many other parts of life, it can be a good idea to follow the crowd.
The Herding Bias isn’t always positive when it comes to investing. Many investors overreact by selling during extreme market volatility, which means the crowd is usually headed in the wrong direction. Going against the crowd, especially in times of uncertainty, can feel very unnatural. But, it’s necessary. Timing markets is next to impossible. Therefore, the best way to achieve long-term investment results is to stay invested and opportunistically rebalance to take advantage of the overreaction of others.
When faced with a decision to either stick with the crowd or stick with a comprehensive financial plan, investors must be prepared to break from the herd knowing they’ve made the decision that is right for their long-term success.