What is Herd Mentality Bias?
In behavioral finance, herd mentality bias refers to investors’ tendency to follow and copy what most other investors are doing. They are largely influenced by emotion and instinct, rather than by their own independent analysis. This guide will provide 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 anyone 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. They’re 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 were actually hired actors. The restaurant hired the actors to sit in the restaurant to make the restaurant look busy. How would 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. The dotcom companies did not have financially sound business models, but everyone bought into it because everyone else was buying into it. You often see herding with analysts recommendations. One of the things to be very wary of is, in fact, we do feel pain when if we go against the crowd. In some instances, psychologists have found that it actually causes physical pain for people to be contrary investors.
So, while everyone’s jumping into Apple stock, if you’re recommending that we actually sell Apple stock, it can cause you and/or a client physical pain.
In fact, in one psychological study, they found that being a contrarian investor or encouraging other people to be contrarian investors, doing exactly the opposite of the crowd, was like actually having your arm broken on a regular basis (learn more in a Morning Star’s interview with James Montier).
The key thing is going against the crowd (or non-conformity) does trigger fear in people immediately.
Thank you for reading this 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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