It is human nature to want to fit in or be part of the crowd. We all like to feel that we belong to a group and are not isolated. Take a moment and go back to your youth…everyone can remember a situation when someone asked us if we did something, “just because everyone else was doing it?” Another favorite that is asked of children and teens is, “would you jump off a cliff if everyone else was doing it?” Investors don’t often ask themselves these questions but as the markets have now crossed into negative territory and volatility is present they certainly should be before rushing into any decisions.
Behavioral Finance is a fascinating field and the better you understand it the better off you are as an investor. A central theme in behavioral finance is the “herd mentality”. Investopedia.com defines Herd Mentality as: “A mentality characterized by a lack of individual decision-making or thoughtfulness, causing people to think and act in the same way as the majority of those around them. In finance, a herd instinct would relate to instances in which individuals gravitate to the same or similar investments, based almost solely on the fact that many others are investing in those same stocks. The fear of regret of missing out on a good investment is often a driving force behind herd instinct.” Every individual has made a decision to fit in or be part of a group but should that include financial and investment decisions? We would answer that question with an absolute NO!
Investors are human and humans are emotional so it’s without question that these two facts overlap when it comes to making investment decisions. Over the last 20 years the individual investor has gained access to the markets through online and discount brokerage firms with discount (if not free) trading and research that was previously only accessible to stockbrokers. This factor also served as a bit of a safety valve as brokers were often able to prevent investors from making emotional decisions and instead focus them on the fundamentals.
The most prominent business schools in the world now have classes covering this phenomena. The Yale School of Management, Massachusetts Institute of Technology (MIT), Columbia Business School and The University of Chicago’s Booth School of Business all have numerous ‘behavior finance’ classes that are included in their student’s core curriculum. If many of today’s brightest minds are aware of how behavioral finance drives the investment world, shouldn’t you be aware of the most critical mistakes to avoid?
Jumping on the ‘hot investment’ bandwagon because other investors are doing so simply makes no sense. There is no historical evidence proving that following the investment herd is beneficial or delivers superior returns. In fact it often will deliver returns exactly the opposite of what is intended! Think back to some recent market trends that investors bought into only to find themselves in a losing investment: the dot-com bubble of the 1990’s and the real estate bubble of the 2000’s. Investors will often discover that they invested in something that was already inflated in price and now they are faced with the difficult decision of devising an exit strategy to cut their losses. Why would investing with the masses ever make sense for the average investor? Everyone has their own goals, risk tolerance, family and professional situations that make them unique.
The most effective way to stay on track is to have a plan. If you are on a road trip do you stop at every intersection and make an emotional decision on which way you think you should turn? You would never do that so why do investors do it with their portfolio? To be successful, investors need to have an Investment Plan or Policy in place to keep them on track. This will also help eliminate any possible decisions based primarily on emotions. It is vital, however, that investors revisit this plan and make changes as their financial situation will change over the years and so will their goals.
The other element that many investors often neglect is rebalancing their investment portfolio once a plan is put in place. An effective rebalancing strategy will force investors to sell assets that have appreciated in price and buy those that are out of favor. If this is done even just once or twice a year it will allow investors to essentially move in the opposite direction of the ‘herd’ and potentially deliver more promising returns. Warren Buffett is considered by many to be the most prominent investor today. One of his favorite sayings wraps our thoughts up accurately….
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