Beware of Following the Herd in Finance

Avoid this common pitfall when making your next investment decision. Steve Schou of Klass Financial explains the problem with herd behavior and how to avoid it.

When it comes to the psychology of financial decision making, let’s talk about a concept which is called “Following the Crowd” or “Herding Behavior.” To be fair, we all run in herds – large or small, bullish or bearish. Institutions tend to herd even more than individuals, by a remarkable degree, in that investments chosen by one institution predict the investment choices of other institutions.
A classic example would be the dot-com bubble, which took place during 1999-2001. The initial public stock offerings of Internet companies emerged with ferocity and frequency, sweeping the nation up in euphoria. Investors were blindly grabbing every new issue without even looking at a business plan to find out how long the company would take before making a profit, if ever.
This type of investor behavior happens more often than most of us would like to admit. The answer to some degree can be found in what some people believe to be a hardwired human attribute called the herd behavior, which is the tendency for individuals to mimic the actions (rational or irrational) of a larger group. There are a couple of reasons why herd behavior happens. The first is the social pressure of conformity. Most people are very sociable and have a natural desire to be accepted by a group, rather than be branded as an outcast. The second reason is the common rationale that it’s unlikely that such a large group could be wrong. After all, even if you are unconvinced that a particular idea or course of action is incorrect, you might still follow the herd, believing they know something that you don’t.
Investors that employ a herd mentality investment strategy usually end up buying and selling frequently, increasing their trading costs in pursuit of the newest and hottest investments. Some herd-following investors use a strategy of pursuing last year’s winners, which many times then becomes this year’s losers. While it’s tempting to follow the newest investment trends, an investor is generally better off steering clear of the herd. Just because everyone is jumping on a certain investment “bandwagon” doesn’t necessarily mean the strategy is correct.
Remember that many times when investments are favored by the herd, they become overvalued based on optimism, not on the underlying fundamentals. When this occurs, it’s not unusual to see a swing from the “hot-tip” syndrome to the “end of the world, the sky is falling” syndrome. The moral of the story is this: if you have implemented a globally diversified investment strategy based on your long-term goals and objectives, then why panic?
We’re all prone to the herd mentality, but if we can recognize what the herd is doing and examine it rationally, we’re less likely to follow the stampede when it’s headed in an unprofitable direction.
Steve Schou is chairman and CEO at Klaas Financial, Inc., 4707 Perry Ridge Lane, Loves Park. He is a CERTIFIED FINANCIAL PLANNER™ professional who helps clients to prepare for retirement – the biggest transition of their lives.
Securities by licensed individuals offered through Investacorp, Inc. A registered Broker/Dealer — Member FINRA/SIPC. Advisory Services Offered Through Klaas Financial Asset Advisors, LLC — A SEC Registered Investment Advisory Firm. Klaas Financial Asset Advisors, LLC is not affiliated with Investacorp, Inc.