Rudolph was taunted by the reindeers, who were behaving cruelly in accordance with herd behaviour. But who can blame them? Herd behaviour plays a significant role in shaping subconscious decisions made by individuals and institutions alike. This phenomenon tends to have people mimic the actions of larger groups, rarely considering the underlying rationale behind those actions. Intelligent investors are aware that they should not follow the ‘herd’, but at times it is not so simple. In this blog, we will explore this very concept of herd behaviour and its impact on financial decision-making and how you can steer clear from the temptations that may arise.
What is Herd Behaviour?
Herd behaviour is a psychological circumstance wherein individuals tend to imitate the actions or decisions of a larger group, rather than making independent judgments based on their own analysis or research. This behaviour is driven by the need to conform, the fear of missing out, and a desire for validation and social acceptance.
In the context of finance, herd behaviour can manifest in various ways, such as following trends in the stock market, investing in popular assets or industries without proper due diligence, or panic-selling during periods of market volatility. The impact of herd behaviour in the financial world can be profound, leading to asset bubbles, market crashes, and irrational price fluctuations.
Examples of Herd Behaviour
Meme stocks – Countless of investors began trading meme stocks in 2021 due to the popularity and attention it received on social media. The more attention it got, the more interested investors became and eventually began trading them.
Stockpiling – At the start of 2020 and when the COVID-19 pandemic hit, shoppers struggled to find specific everyday necessities such as toilet paper and flour. That’s because people noticed that others were stockpiling these items. With no rational reason to overcompensate, more people felt the need to pile on these items too.
House market bubble – In the mid-2000s as home prices continued to rise, more and more people rushed to invest in real estate, believing that prices would continue to rise. This collective optimism fuelled the housing bubble, which eventually burst, in part triggering the global financial crisis of 2008.
How Does Herd Behaviour Affect Your Financial Decisions?
Herd behaviour can have a significant impact on individual financial decisions, often leading to suboptimal outcomes. When investors follow the crowd without conducting their own research or seeking professional advice, they may be more susceptible to market volatility, misinformation, and emotional biases.
The presence of herd behaviour can pose a challenge for both clients and advisors. Clients who are influenced by herd mentality may make impulsive decisions based on short-term trends or popular sentiment, rather than considering their long-term financial goals and objectives. Fiduciary financial planners, on the other hand, must navigate these dynamics to effectively guide their clients towards sound and prudent financial decisions.
How to Avoid Following the Crowd
To avoid succumbing to herd behaviour and its potential pitfalls, investors can take several proactive steps:
Develop a well-defined financial plan: By clearly outlining your financial goals, risk tolerance, and investment strategy, you can stay focused on your long-term objectives, rather than being swayed by short-term market trends.
Diversify your portfolio: Building a diversified investment portfolio can help mitigate risk and reduce the impact of market fluctuations. By spreading your investments across different asset classes, industries, and geographies, you can avoid overexposure to any single asset or sector.
Consult with a fiduciary financial planner: Working with a fiduciary financial planner who is obligated to act in your best interests can provide you with valuable guidance and expertise. A fiduciary can help you navigate market volatility, avoid common pitfalls, and make informed decisions based on your unique financial situation.
Stay informed and educated: Staying on top of market developments, economic trends, and financial news can help you make more informed decisions and avoid falling prey to the influence of herd behaviour. By conducting your own research and seeking out reputable sources of information, you can make sound investment choices.