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Herd behavior: don't be a lemming!

January 09, 2019

Beware of hypes

Around the end of 2017, bitcoin investors let the corks pop: Since the beginning of the year, the cryptocurrency had seen an almost twentyfold increase in its value, and on December 17, 2017, it even briefly cracked the 20,000-dollar mark. What has happened in the course of the hype? To begin with, some institutions had realized the potential of blockchain technology and invested in bitcoins, which are based on it. What happened next is reminiscent of the behavior of lemmings: More and more private investors got bitten by the bitcoin bug - until the cryptocurrency eventually went into a sudden and steady decline in mid-December 2018.

Picture of a Bitcoin fading
What happend to Bitcoin is a good example of herd behavior. Photo © CC0 Licence

As early as the beginning of 2017, Yale finance professor and Nobel laureate Robert Shiller described bitcoins as an experiment that bore all the hallmarks of a bubble. What has happened to bitcoin investors also happens elsewhere every day: When you are watching a sitcom and cannot help joining in with the off-screen laughter. When you buy a plastic box at the Tupperware party just like your friend. Or when you go with an overpriced mainstream opinion although you actually know better.

Insecurity makes us do what others do

In behavioral finance, this phenomenon is called herd behavior. We tend to model our behaviors on the “herd” when we feel insecure, when we believe the group is more competent at making assessments than we are, when we do not want to stand out or when we are anxious not to make a fool of ourselves. Also, we follow the herd because we seek acceptance and recognition. The more we want to belong to the group, the likelier we are to conform to its behavior. From a human point of view, this is perfectly understandable. In an investment context, however, following the group may turn out to be a costly mistake. People who know nothing about bitcoins parrot the opinions of others and invest a good deal of their savings in a product they don't understand well enough.

Picture of a herd of sheep
We follow the herd to get acceptance and recognition, and because we believe the group is more competent. Photo © CC0 Licence

Herd behavior can, of course, be rational - when the group indeed knows more than the individual. However, on the financial markets we constantly see examples of people's tendency towards irrational herd behavior: the dot.com bubble, exaggerated stock-price reactions during the 2007-2009 financial crisis, the financial euphoria over Eastern Europe, which, by now, has transmuted into the very opposite: All of these developed to an extent that was no longer rationally justifiable.

Tips

So, beware of fads and so-called “hypes” - especially if they attract a lot of media attention. Never follow them blindly, but always take a closer look and carefully weigh the pros and cons with a goal of to making sound decisions. Ask yourself: “Am I following the ‘herd’ without reflecting on my actions because I am not sure what to do?” Also, question whether the others have better information than you.

When it comes to making investment decisions, ask yourself: “Would I also buy or sell this share if the others did not?” Analyze the industries and businesses in question based on their fundamental, i.e. rationally justifiable, values. If you come to the conclusion that a share's price is unjustifiably high as a result of herd behavior, you had better not buy it. If you already are a shareholder, sell your shares and capitalize on the fact that the “herd” has caused the company to be overvalued. Apply the same logic, mutatis mutandis, to acquiring a share. Buy it when its price is low in comparison to its fundamental value. As stock-market guru André Kostolany put it: “Buy when the canons are roaring!” In this context, it is also helpful to consciously “reframe” the development of prices on the capital market: If there are many orders to buy and prices go up as a result, this can also be interpreted as follows: The very fact that so many investors have bought the share and that its price has increased sharply may mean it is already overvalued. The opposite is true with regard to price plunges.

This article was published in the Austrian business magazine GEWINN. Read the original article here (in German).

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