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Behavioural Biases And Their Effects On Investment Decisions Series – Part 1

Behavioural biases are quite common in everyday life. To some extent, all of us have certain biases about the people, communities, businesses and the government around us. If we were to look at the world without the filter of our biases, it would present a totally different picture. However, it does not seem possible. All our judgements pass through the filters of our behavioural biases and make our decisions skewed.

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Behavioural Biases
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The same applies to the investment decisions as well. Most of the investors make assumptions, judgements and investing decisions based on the stereotypes that exist in their minds. These stereotypes colour the picture seen by the investor the way they want to look at it. This leads to incorrect and unsuccessful investing decisions, resulting in losses many a times.

Herd Behaviour

One of the most common behavioural biases is the Herd Behaviour or Herding. Herd behaviour represents the behaviour of an investor to follow the actions and decisions of a large group of people, without analysing whether they are rational or irrational.

Herding has caused many significant and huge losses in the investment market. This includes the financial crisis of 2008, which can be party attributed to the herd behaviour. Multiple financial players in the market got involved into irrational herding and started following the masses. They stopped giving a thought to their decisions and considered what others were doing as the correct approach. This led to all of them losing big, all at the same time, leading to the huge crash.

Causes of Herding

Various research studies on human behaviour have confirmed that herd behaviour is majorly caused due to the humans’ basic need for social conformity. The reason for making a herding-driven decision is mostly that everyone else is doing the same. The investors tend to cling to what everyone else is doing and do not want to stand out by doing something drastically different. They want to remain socially acceptable and not be considered outcasts.

Another significant reason for herd behaviour is the assumption that when majority of the people are doing something, it must be the right thing. The more people support a decision, the less likely is that decision to be incorrect. Therefore, the herd behaviour becomes more prominent when the investors are less experienced and less confident. They tend to follow the herd more at such times. Also, it is easier to follow others and go with the flow, rather than taking contradictory decisions.

Effects of Herd Behaviour

Herd behaviour leads to the market getting swayed in one and only one direction. In terms of investing, when one group starts selling the shares of a particular company, herd behaviour comes into action and almost everyone starts following them. The price of the stock falls drastically due the mass selling. Now, the reason why the first group started selling the shares could be rational or irrational, but the herd followers almost never verify the facts and follow the herd blindly. This leads the market to move in one direction, without a specific cause or reason, at most times.

Similarly, herd behaviour has led to bigger and very significant financial market situations. The dot-come bubble of 1999-2000, the credit bubble of 2003-2007 and many other investment bubbles have been formed and burst due to rampant herding. When the property prices started rising in 2003-2004, everyone wanted to be a part of the growth and started herding to buy houses. Homebuyers were further encouraged by the mortgage companies, who started making subprime lending arrangements. The herd kept increasing and the basis or the rationale was never verified. Due to the weak foundations, the bubble burst and the delinquencies went high enough to cause the financial markets to collapse.

How to Avoid Herd Behaviour?

Just like any other form of behavioural bias, herd behaviour colours the judgement of the investors and prevents them from making rational decisions.

It is always advisable to not follow the herds and trends. This is called the contrarian approach, wherein the investor does exactly opposite of what others are doing. When others are buying, the contrarian investor will sell, and vice versa. Warren Buffett is the most successful example of contrarian behaviour. However, it is to be kept in mind that the contrarian approach is quite risky and must be practised with extreme caution.

The most suitable solution is for the investors to follow an individual, practical, well-researched approach. The investors must remain balanced and rational, and follow the herd only after analysing the behaviour. They must form their independent strategies and investment principles, rather than following a trend that has a high tendency to go wrong. So, there is nothing wrong with following the trend, once you have done your research and are convinced that the decision is rational enough.