What is Herd Mentality Bias?
In behavioral finance, herd mentality bias refers to investors’ tendency to follow and copy what other investors are doing. They are largely influenced by emotion and instinct, rather than by their own independent analysis. This guide provides examples of how investors may succumb to herd bias, as part of behavioral finance theory.
Behavioral Finance Overview
There are four buckets of decision-making errors and biases in behavioral finance. These four buckets of biases and errors are:
- Self-deception – refers to limits to learning.
- Heuristic simplification – refers to information processing errors.
- Emotion – how our mood affects our decision making.
- Social – how we’re influenced by others, which is where herd mentality comes in
Restaurant Example of Herd Mentality
Let’s look at an example of how the herd bias can affect someone in real life. You’re in a new city and you’re looking for a place to eat. It’s early evening and you see two Greek restaurants right across the street from each other.
Which restaurant do you choose? The one that’s crowded, full of people, or the restaurant with a lot of open tables?
It’s interesting – we’re hard-wired to herd. When asked, most people will choose the busy restaurant over the empty restaurant. While some may be rationally concluding that the busier restaurant probably has better food (which may or may not be true) many are just making their decision based on the decision of others.
But what would happen if I told you this? – That, in fact, the first few tables of people in the busy restaurant were actually comprised of hired actors. The restaurant hired them to sit in the restaurant to make the place look busy. How might that affect your decision?
Herd Mentality in Financial Markets
The key thing is that we are hard-wired to herd. There is a large weight of evidence of herd mentality bias in the financial markets. You can think about the dotcom bubble. Many dotcom companies did not have financially sound business models, but many investors bought into them because everyone else was buying into them. You often see herding with analysts’ recommendations. One of the things to be very wary of is that we often find it emotionally or psychologically painful to go against the crowd. Think about a circumstance where you stifled your desire to do something because everyone else in your group voted to do something else. Psychologists have found that it may actually cause physical pain for people to be contrary investors.
So, if everyone’s jumping into Apple stock, if you’re recommending selling Apple stock, it can cause you and/or a client physical pain.
In fact, in one psychological study, they found that regularly being a contrarian investor or encouraging other people to be contrarian investors was somewhat like actually having your arm broken on a regular basis (learn more in Morningstar’s interview with James Montier).
Going against the crowd (or non-conformity) typically triggers fear in people immediately. Why? Because everyone else saying “A” makes them fear that they might be wrong in thinking “B”. They additionally may fear being embarrassed or appearing foolish if they go ahead with choice “B” and it turns out to be wrong.
Thank you for reading this CFI guide to how herd mentality can impact investors. CFI offers the Financial Modeling & Valuation Analyst (FMVA) designation, designed to help turn anyone into a world-class financial analyst.
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