27 Jan Investment Downfalls: Herd Behaviour
Herd behaviour is pretty self-explanatory; it is where you follow others rather than make your own decisions and it is quite common to experience when investing. Herd behaviour is driven by emotions rather than rational behaviour. Often little attention is paid to investment fundamentals as investors focus on what other people are reacting to in the market. A diverse investment portfolio and a financial planner can reduce your chances of falling into the trap of herd behaviour, here is what to look out for.
What is Herd Behaviour?
All investors are prone to behaviours and emotions that can lead to poor investment decisions. Herd behaviour is a common pitfall that can describe large numbers of individuals acting in the same way at the same time, typically by buying into rising markets and selling out of falling markets.
Signs of Herd Behaviour
Investors often experience emotions of optimism and greed when markets are rising, and fear and panic when markets are falling. Little attention is paid to the investment fundamentals, which means herd behaviour rarely leads to successful investment outcomes.
There are two main drivers of herd behaviour when it comes to investing. Firstly, people don’t want to miss out on making a profit. Secondly, we assume that when a large number of people are buying into the same investment, they can’t all be wrong. This means that there is often little understanding of the underlying investment, and more attention is focused on what other people are doing. Consequently, it is often the less experienced investor who gets caught up in herd behaviour.
Consequences of Herd Behaviour
This behaviour can cause markets to dramatically rise and fall in value – known as ‘bubbles’. Bubbles can only be identified with hindsight after a rapid and marked drop in value has occurred. These sudden drops are sometimes referred to as ‘crashes’ or ‘bubble bursts’. Bubbles are only identified in retrospect. Many investors often get caught out by the sudden and rapid decline in the value of their investment. A great example of a bubble burst was the housing market bubble burst in 2008 just prior to the Global Financial Crisis.
Bubble burst indicators – what to watch out for
- Strong, sustained rallies and stretched valuations
- Hearing ‘this time it’s different’
- A flurry of initial public offerings, mergers and acquisitions
- Investor greed and a fear of missing out
- Everything moving together, regardless of quality
- Media headlines talking up the latest investment trend
Case study of Herd Behaviour
It’s October 1999 and Ken has been keeping an eye on the share market. Everyone is talking about the exciting future of technology companies, and he has noticed most of them have doubled in value during the past 12 months. He doesn’t know much about investing or technology companies but assumes all the other investors know something that he doesn’t.
Without really understanding why the stocks are rising, he invests $10,000 in a technology-based index fund. Ken was reassured that many other investors are doing the same. Four months later he is delighted that the value of his investment has risen more than 50%. All those people were right after all.
Then in February 2000, his investment started losing value and Ken can’t see any reason behind the fall. All of a sudden everyone is rushing to sell their technology stocks, and no one is buying any; the exact opposite of just a few weeks earlier. The drop in value is so abrupt that by the time Ken reacts and sells his holdings, he has lost most of his original investment.
Like many others who had jumped on the ‘dot.com’ bandwagon, Ken did not do his research and invested without fully understanding the sector or risks. He thought to himself “this time it’s different”. Looking back he acknowledges that the signs of a bubble were there for all to see.
Avoiding Herd Behaviour
One way to avoid such a pitfall is to invest in a professionally-managed investment fund. Managed funds will typically have a disciplined investment process that is designed to meet long-term investment goals, rather than be concerned with following the latest trend. Most managed funds will also have a team of analysts who will research and analyse companies based on proven economic measures, rather than relying on the emotions of others.
Invest Intelligently with a Financial Planner
While it’s tempting to follow the latest investment trend, it is imperative to always fully understand an investment before making an investment decision. A financial planner can help you make intelligent decisions with your investments and help you navigate volatile or new markets. If you want to begin investing, get in touch with the Master Your Money Now team and we can help you identify the right investments for you.