Herding bias: following the herd, fearing isolation

Herding bias is thought to be the most influential bias in trading markets. In a 2015 survey by the US CFA Institute 34% of members ranked it the most influential. Its nearest rival – confirmation bias – was named by just 20%.

Herding is simply following the herd, doing what others are doing, following the trend, fashion or craze. And it especially means following the herd when your own analysis, logic and instinct tells you to buck the trend and do something different.

With investments, the herd instinct leads to widespread investing in particular markets or even individual stocks or shares, sometimes causing prices to rise quickly. It is considered the main cause of bubbles, including the dotcom bubble.

Reasons to flock

There are both push and pull factors at play. The crowd is usually right – most of the time lots of people think something is a good thing because it is a good thing. Not following the herd would be stupid.

But if you get it wrong and your investment goes down, being part of that crowd makes you feel less negative than if you were on your own. Go it alone and get it wrong and the crowd will laugh at you. It was your mistake, nobody else’s. There’s nobody to blame.

A similar sized error will feel many times bigger if you were taking an unorthodox route rather than conforming. There is also the negative feeling associated with being an outcast.

Loner or maverick?

Going against the herd can be hard. There are subtle differences in language. Fail and you will be dubbed a loner, a recluse, a lone wolf or an outsider. Maybe you’ll just be called a weirdo or kooky.

Succeed and a different dictionary is used. A maverick is a badge of honour. Being described as eccentric, Left Field and nonconformist feels empowering. You will have shown independent spirit or be seen to have ‘cojones’.

But, for many, the risk of negative name-calling outweigh the potential feel-good factor of being a superhero.

Herding instinct

Herding, based on emotional responses such as fear, envy or greed are often portrayed as irrational. But herding is natural, according financial psychiatrist Kim Stephenson.

It is a primitive defence mechanism. Cavemen were more successful – and safer – when they hunted as a herd and shared the spoils.

Go hunting alone and you could come back empty-handed and your family would go hungry. Worse, you could be attacked while alone and be injured or killed.

Trash TV

Group behaviour remains relevant today. “In the modern day it’s all about watching the same TV programmes, kow-towing to the same people,” says Stephenson.

“In the tribe, if you were friends with the chief you didn’t get the nasty guard duty or get stuck in front of the charging buffalo as bait while the rest were sneaking up behind it.

“Nowadays it’s about grovelling to the boss and watching the right reality TV so you have the right things to talk about at the water-cooler.”

Vicious circle

The risk is that herding exaggerates an unsustainable market trend. As growing numbers of investors pile in to a specific stock, for example, the price rises. So more investors are attracted, assuming the herd must be right because the price is rising.

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The result is that the price moves further and faster away from a value justified by its underlying fundamentals. When the market finally realises this, the market correction is sharp and, often, shocking. The bubble bursts.

Avoid the herd

The general advice is not to follow the herd blindly. Do your research and invest in the products, stocks or financial instruments that your fundamental analysis suggests will generate the best rate of return.

Stephenson goes further. He says you should first decide what return you need and the best way of achieving it. As everyone is different, with different demands and needs, there is no right or wrong answer.

His suggestions are:

• How much do you need?
• When do you want your money (liquid or illiquid)?
• How safe do you want it?
• What’s the required rate of return?

“What are you planning to do that you cannot afford now? How much can you allocate to that and what rate of return do you need to achieve it? If there is a safe investment that can get you that return, why take a greater risk?” he asks.

Stephenson’s final word is: “People ask what everyone else is doing. If someone asks ‘what’s a good investment?’ the answer should be ‘what do you want to achieve?’.”