Herd Behavior and the Bandwagon Effect in Investing

“Be fearful when others are greedy, and greedy when others are fearful.”

— Warren Buffet

When stocks appreciate over time, investors get excited and they praise their financial advisor for their performance results. It is easy when everyone you know has been making money. People who are not usually involved in the market get suddenly interested and jump on the bandwagon.

We have a natural human tendency to join the crowd. There are situations where it’s a good idea (for example, rushing to the exit in the case of a fire), as well. However, in the world of investing, it can be counter-productive.

In fact, Warren Buffet is renowned for building a fortune on sound financial decisions made contrary to most others’.

Popular Problems

Three behavioral finance biases explain investors’ tendency to follow the crowd above their own analysis and wisdom: herd behavior, the bandwagon effect, and confirmation bias. Once learned, anticipating these patterns can help you become a smarter investor. As your Kansas City financial advisor, we want to see you making independent decisions when others are blindly following the crowd. The tendency for people to imitate larger groups is often referred to as herd behavior or the bandwagon effect.

Basically, it refers to when people turn off their own critical thinking. Instead of asking questions, they default to, “Everyone else is doing it, so it must be okay.” As a result, they fall in step without thoroughly considering possible results.

Sometimes they even ignore or override their personal thoughts and beliefs. Herding is good for wildebeest, but in the domain of finance, it can inspire irrational behavior and contribute to market bubbles. Fear, uncertainty, and influential celebrities can be powerful drivers of herd behavior.

Often, it may be the layered effect of two, simultaneously. For example, Joe Portfolio hears all day from coworkers, friends, and family who are selling their stock in a company they see as doomed. Next, at home that evening, talking heads all parrot news of the same company’s lowered stock value.

Being human, Joe starts to wonder if he should liquidate his own shares of the same stock. However, rather than taking a deep breath and then researching the company—and potentially temporary factors like widespread U.S. supply chain issues—he starts to worry.

Unfortunately, this can trigger stress hormones that actually lower your IQ for a while. Joe might be MENSA material under normal circumstances, but his best financial decisions are extremely unlikely now. Investors who notice this about themselves—and pull over tend to catch their breath—often fare better in the long term.

Confirmation Bias

Do you like to be wrong? If your answer is “No,” you’re in good company. Most people prefer so strongly to be right that they seek information confirming what they already think, ignoring any data to the contrary. This tendency is called confirmation bias.

It can cause investors to selectively process information about assets so they only see the factors that support their existing opinion. Since confirmation bias leads to abandoned objectivity, it can potentially lead to a lack of diversification in your portfolio.

As a result, you can wind up accepting or keeping too much risk, especially through long positions. This can be especially unhealthy for your holdings during periods of market volatility. Let’s take for example a scenario where rising inflation is spurring the Fed to make interest rate hikes.

Higher interest rates normally lead, for example, to a lower value for fixed-income bonds. Meanwhile, floating-rate bonds become a hot item due to their increasing returns. Conversely, when interest rates are calm, the opposite happens; fixed-income assets become hot properties again and floating-rate assets lose their high-inflation edge’s appeal.

As a rule of thumb, the art of profitable investing lies neither 100% in unblinking adherence to a specific strategy nor 100% in flitting from trend to trend. A degree of informed, semi-flexible commitment positions you to take in information and make sound decisions.

So, if Joe Portfolio is cognitively biased toward, for example, news outlets singing the praises of fixed-rate assets, he is likely to miss out on potential gains. At worst, if he does not perceive the need to diversify his assets, his entire investment nest egg could lose significant value over time.

The more aware we are of these often-hindering cognitive habits, the better we can compensate for them and make sounder investment calls.

Wealth Management Goals: Think For Yourself

Investing, clearly, is a long-term endeavor, so there is ample room for confidence. We just need to verify that we are data-assured instead of self-assured (or herd-assured). Reliable financial confidence stems from a realistic view informed by facts.

This requires a combination of positive habit-building and applied financial logic. As complicated as this might sound, it boils down to watching for signs that you are tempted to worry or panic and disciplining yourself to take a breather before you react.

Conversely, assumptions based on hearsay and trends often blind us to crucial insights and potentially favorable opportunities. For instance, many people may panic and dump still-promising stocks during volatile or bearish market conditions. However, if you have the cash to invest under these circumstances, these shares may constitute a once-in-a-lifetime opportunity to buy outstanding assets for peanuts.

If you would like help identifying today’s hidden gems, we are always happy to help. If you are unsure whether your assets include investments for current market conditions, make some time to connect with us for a full financial portfolio review.

Even if you are between advisors, we have the experience and expertise to help balance out your portfolio. In fact, we believe that we have independent wealth solutions for every style of investing. Reach out and contact us today.