Herding bias can be injurious to financial health
We might like to think that we make decisions based on our independent assessment. Not really. A new study by the Journal of Consumer Research called ‘Social Defaults: Observed Choices Become Choice Defaults’ suggests that we are prone to being copycats. Participants were asked to choose products. Rather than spending time learning about the product or asking questions, they simply mimicked the choices of the crowd. This phenomenon is also known as herding bias.
Herding bias is common mainly because as human beings, we have a natural desire of being a part of the herd. Staying in numbers makes us feel safe. Following the crowd has helped us survive. During the Stone Age, if we saw a group of people running away from something, it would be a good idea to join the group and run with them, rather than explore the reason for their flight. This learned behaviour has stayed with homo sapiens for ages.
The idea of moving with the crowd is so deep-rooted in our psyche that we make many decisions based on where the herd is. For example, while deciding between two restaurants, are you likely to choose a busy one over an empty one? Though completely unscientific, more ‘patrons’ is associated with ‘superior taste’ and ‘better quality’. E-commerce websites publish a cluster of complementary goods under an unthreatening banner titled ‘What other items do customers buy after viewing this item’, just to induce the next customer to buy it. OTT streaming platforms encourage binge-watching by flashing ‘Customers who watched this movie/series also watched xyz movies’.
These marketing messages are a play on herding behaviour. Investment decisions are no different. While taking financial decisions, when investors copy what others are doing rather than relying on expert advice, it leads to ‘herding’.
We witness herding when a particular sector, a segment of the market (like mid- or small-caps) or an asset class (gold/equities/realty) is at its peak. Investors have a tendency to over-allocate to the flavour of the season. In a recovery rally post the 2007-08 financial crisis, the IT sector saw high allocations, only to underperform for the next two years. Similar was the case with realty (CY17-18); the CY20 rally in pharma has attracted a lot of funds.
While the entry points seem very obvious, not knowing when to exit can be painful. Following the herd makes you enter the rally at its peak and exit it at the nadir, seriously hampering your finances in the process.
Favourable asset class cycles do not last and winners rotate their stance. Winners of the year end up becoming underperformers of the subsequent period. The consequences of herding bias playing out in the financial markets can be very dire.
So, how can we avoid falling prey to herding bias while making financial decisions?
Research: Studies have shown that we tend to follow the herd more when we have less knowledge about the subject. Hence, reading more about the investments and increasing our knowledge is the best defence against the bias.
Seek professional advice: Self-medication is proven to be harmful in most cases. Since investing also requires analysis of many factors that are constantly changing, an expert’s advice should be sought.
Keep emotions in check: Avoid impulse buying and selling. Transactions based on a formula or preset rules will help avoid emotional pitfalls.
Compounding is more powerful than absolute near-term returns: The longer you are invested, the more you are rewarded, thanks to the power of compounding. The human mind, which is wired for linear thinking, believes if 15% compounding makes money 4x in 10 years, then in 20 years it should become 8x and so on. However, 15% compounding in 20 years multiplies your investment 16 times and in 30 years it multiplies money a whopping 66 times.
So, investing is more about behaviour than IQ or predictions.
Navin Agarwal is MD & CEO, Motilal Oswal AMC.
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