The Herding Mentality: Behavioral Finance and Investor Biases
Behavioral finance has been around for some time in one form or another. For instance, for much of the last hundred years, a leading Wall Street investment bank is reported to have kept in its head office a copy of Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay.
Like a medicine, prospect theory has been prescribed by many as a potential panacea for most if not all investment practitioners. Yet, heuristics — mental shortcuts — and other biases continue to affect some of our professional choices, leading us to make mistakes. For a gifted few in the industry, biases are a source of alpha. But for many others biases impose a cost — a price paid for irrationalities.
Financial markets reflect these irrationalities and collective biases. The current state of global markets is not as extreme as the post-Lehman gloom. But substantial reversals in the Chinese stock market and other popularly tracked market moves — oil and gold among them — may be an interesting market backdrop to understand collective investor behavior. To get a sense of the current sentiment and investor biases, CFA Institute Financial NewsBrief administered a survey this week asking readers to select the behavioral bias that affects investment decisions the most.
The survey generated responses from 724 practitioners from across the world. As shown in the graph below, herding garnered 34% of the votes and stood out as the topmost bias affecting investment decision making in the eyes of poll participants.
Poll: Which of the following behavioral biases affects investment decision making the most?
The best way forward for herds is to follow others. Herding takes place when collective actions carry better and and more useful information compared to private knowledge. Reinforcing group actions ultimately overwhelms individual conviction and creates a trend. While all herding is not irrational — for example, when very little information is private, like during the slow yen decline that started in 2012 — the top ranking for herding in this survey indicates, among other things, uncertainty and an information deficit. Some markets may have an intrinsic tendency to herd. China’s rapid stock market value erosion and the high rank for herding in this survey support studies that suggest a prevalent herding mentality in developing markets.
In its best iteration, herding helps bring prices closer to fundamentals. But continued and complete imitation without regard for reason can extend valuations away from true business value. Decision making guided by herding can result in an environment where asset correlations are high. Short-term trading and momentum strategies are expected to dominate in such a setting.
Confirmation Bias and Others
Interestingly, confirmation bias. with 20% support, was ranked the second-most influential bias. Confirmation bias is a tendency to search for and assimilate data that confirms beliefs but to overlook evidence that contradicts them. So, in isolation, the relative lack of support for this bias is healthy — as a larger percentage of decision makers are not vulnerable to being “conformists.” This result, in conjunction with the top vote for herding, suggests that practitioners may be taking decisions based on group behavior, albeit in a relatively uncharted, uninformed space.
Overconfidence — the tendency to overestimate one’s skills and knowledge — secured a low 17%. This suggests a lack of optimism and limited conviction in the decision-making process. Availability bias — judging outcomes by known experiences — received 15%, and loss aversion — disliking losses more than liking gains — earned 13%.
The top rank for herding is a reminder of the lemming suicide myth. According to the myth, lemmings end their lives by following one another and then jumping off a cliff. Who knows? Perhaps the mythical lemmings may have better data. As they step off the proverbial precipice, the lemmings may be entering a world in better shape than the current one. Nevertheless, investors may want to question the lemmings in the actions that they take and be wary of fads as they differentiate fact from fancy.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.