Herd Bias is a Powerful Force in Markets

Herd instinct is the observed human behavior which causes us to join groups and follow the actions of others. Also known as bandwagon effect, it can explain why people take various actions. It has even been observed in small children who will often want to do “what everyone else is doing.” For investors, herd bias can move markets strongly to the upside, but unfortunately, also to the downside.

An investor who displays herd bias is very conscious of market momentum and often concentrates his/her investments in the popular names. Often choosing high profile individual stocks, the herd investor commonly holds a concentrated, un-diversified portfolio. In addition, these people have a tendency to rely on the research work and/or opinions of others, as opposed to independently analyzing a prospective investment on their own.

The dot-com stock bubble of the late 1990’s is a classic example of herd bias. Investors piled into anything that was remotely related to the internet. The stock prices of unprofitable companies were driven sky high by the premise that they were part of the “next big thing”. Fear of “missing out” was rampant, but unfortunately, the boom came to an end in 2000 and imposed severe losses on panicky sellers.

Investors can work to overcome herd bias. They can study the facts for themselves and ask questions about how and why other investors are taking certain actions. Being a contrarian can be difficult, but doing so will often prevent expensive mistakes. Maintaining a well-diversified portfolio is also a fundamental step to counteracting the effects of herd bias.

If you would like to learn more about these and other wise financial planning moves, please contact us through our Level 5 Financial LLC website or via phone at 719-323-1240.  This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice.  You should consult your own tax, legal and accounting advisors before engaging in any transaction.