Herd behaviour

All investors are prone to behaviors and emotions that can lead to poor investment decisions. One of the most common pitfalls is known as ‘herd behaviour’. This describes large numbers of individuals acting in the same way at the same time, typically by buying into rising markets and selling out of falling markets. This behaviour can cause markets to dramatically rise and fall in value – known as ‘bubbles’.

Bubbles can only be identified with hindsight, after a rapid and marked drop in value has occurred. These sudden drops are sometimes referred to as ‘crashes’ or ‘bubble bursts’. Because bubbles are only identified in retrospect, many investors often get caught out by the sudden and rapid decline in the value of their investment.

Herd behaviour is driven by emotional rather than rational behaviour. These emotions are typically optimism and greed when markets are rising, and fear and panic when markets are falling. Little attention is paid to the investment fundamentals, which means herd behaviour rarely leads to successful investment outcomes.

There are two main drivers of herd behaviour when it comes to investing. Firstly, people don’t want to miss out on making a profit. Secondly, we assume that when a large number of people are buying into the same investment, they can’t all be wrong. This means that there is often little understanding of the underlying investment, and more attention is focused on what other people are doing. Consequently, it is often the less experienced investor who gets caught up in herd behaviour.

Bubble indicators – what to watch out for

  • Strong, sustained rallies and stretched valuations
  • Hearing ‘this time it’s different’
  • A flurry of initial public offerings, mergers and acquisitions
  • Investor greed and a fear of missing out
  • Everything moving together, regardless of quality
  • Media headlines talking up the latest investment trend

 index peaked

Source: Bloomberg. Chart is used for illustrative purposes only.

While it’s tempting to follow the latest investment trend, it is imperative to always fully understand an investment before making an investment decision.

Speak to your financial adviser if you have any questions about herd behaviour.

“Be greedy when others are fearful and fearful when others are greedy” – Warren Buffet

Solace Financial