You’ve undoubtedly heard the phrase “If so and so jumped off a cliff, would you?” at least once in your lifetime, and no doubt it was said to you by someone older and wiser. The lesson to be learned by this phrase is that you shouldn’t always follow the herd and cave in to peer pressure; you should always keep your wits about you and make your own decisions or else you will be blindly led to your downfall.
This old adage refers to an ancient truth about human behaviour that maybe we aren’t too happy with. It refers to herd mentality, or herd behaviour, and it is hardwired into our instinctual behaviour. Herd mentality refers to when individuals come together and form a group, and then act collectively without independent thought or decision making. There is no direction of thought, but the mob takes on a mind of its own and can lead to behaviour in people that they would not necessarily do by themselves. This phenomenon has been observed multiple times in human history, with leading examples being riots, demonstrations, religious events and sporting tournaments.
Herd mentality is not always a bad thing – it is a survival mechanism that helps us as human beings make quick decisions and take quick action through social referencing which, back in the day, could mean life or death. However, in this modern day and age, this hardwired evolutionary hangover can have a significant impact on our decision making.
An analytical paper by Fromlet outlines just how herd behaviour can be observed in the investment world. He states that well known and successful investors are watched closely to see what they are going to do, and their movements are copied by other investors. This soon leads to a tipping point where investors are flocking to the same stock, which in turn drives up the value and attracts more investors. Eventually, investors are almost forced to invest in the stocks that everyone else is invested in.
This psychological bias has led to a phenomenon in stock markets called “bubbles”. Bubbles are when the price of an asset quickly surpasses the actual value, because of excessively positive market behaviour in its favour. What this means in plain speak is: a stock’s value goes up way past what it is worth because loads of people are buying it. The problem with bubbles is that they are not sustainable – there will eventually be a point where the price of stock is so high that no one will want to buy it. At this point, the bubble will begin to collapse and this can happen quite quickly and with severe consequences.
One notable example of a bubble occurring is the dot-com bubble of 1995 to around 2001. This happened where stocks in the Internet sector were bought up with reckless abandon. This period saw many internet based companies being founded – and they could rapidly increase their stock value just by adding a .com to the end of their name. Investors were buying these stocks overconfidently and were disregarding more traditional indicators of value in favour of the hope that technology would keep up with the value spikes. Unfortunately this didn’t happen and many internet start ups failed when the bubble burst, while many saw their stocks drop sharply in value.
So how can we avoid becoming a part of the herd? It is not that easy because we may be fully aware of what we’re doing but completely unable to fight the tide. The trick is to keep a level head and make sure you’re looking at the numbers. Stop yourself and ask -“Am I being too confident?” If the answer is yes, then slow down and take a look at the numbers and make sure you look at traditional metrics like the P/E ratio. If you’re eyeing up a stock, taking a look at its history to see if it has rapidly increased in value – are you looking at the back end of bubble? If so, it may not be a good time to invest. In all, make sure you get a good idea of all information available on the stock – both good and bad – to make sure you make the best informed choice you can possibly make.