Exo Investing Blog

The subconscious biases putting your investments at risk - Part 3

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We’ve made it to part 3 of our series on the dangers of human bias in investing.

In part 1 we covered Loss Aversion, part 2 focused on that wonderful thing called Hindsight, and now we’ll be breaking down Herding.

As always, we do our best to translate everything into our favourite language, ‘normal people’.

What’s this herding issue then?

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Herding, often referred to as herd behaviour or herd instinct, is exactly what you think it is. Just like a wild animal’s need to stay part of a herd for protection, human’s still have this same need ingrained into us.

Whether because of a deep down genetic marker from our primitive years, or a modern social pressure to be accepted by the group (both on and offline), herding still exists in everything we do.

From a consumer perspective, just think of the major toy crazes (hysteria) we’ve been through in the last few decades that seemingly come out of nowhere to reach pandemic levels of demand outbreak. Examples that spring to mind are Tickle Me Elmo, Beanie Babies, Tamagotchis, Furbies, Micro Scooters (although some commuters seem to have brought them back), and I’m sure there are many many more to add to the list.

All of these were seemingly the ‘must have’ for children around the world - sending parents to the deepest darkest corners of society to purchase them. (There was even a critically acclaimed documentary about it)

When we look back at these points in time, it seems so insignificant and such a small timescale, but we can also remember just how big of a deal it was for those few days, weeks or months before the demand simply died.

When applied to investing, herd instinct can be equally persuasive and start to create negative outcomes - and large ones at that.

Examples of herding in investing

As we mentioned when covering Hindsight bias in part 2 of this series, herd instinct has been a major contributor to ‘bubbles’ and crashes.

The dotcom bubble was a great example of the dangers of herding, where it fueled the rapid growth and subsequent burst of that bubble. Using our wonderful hindsight, this all seemed obvious it was going to happen. Yet, at the time, herd mentality meant we feared missing out on those soaring dotcom stocks that could be the next ‘big thing’.

For those that claim they stayed away from all of this, just remember that hindsight bias can conveniently help us forget what we got wrong, and instead focus our memories on the more pleasant wins.

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Now, that’s an extreme whole of market example, but we can see it happening with individual stocks as well.

There’s much deliberation over whether we’re approaching a ‘tech bubble’ that will mirror dotcom. The past decade has seen herd instinct kicking in around each next big tech company that makes it to an IPO, with investors flooding to get a piece of the pie.

Whether it really is the next great company or not, we have to acknowledge that due diligence by individual investors is probably not being taken on the stocks underlying financials.

We know deep down that it may not be the best/safest/wisest move, but we equally can’t help but feel we’ll be missing out if we don’t join in.

But, we aren’t here to predict what’s going to happen, or whether this will or won’t cause another crash. If we could, we’d be retired on an island somewhere with our billions.

So what can we do about it?

Warren Buffett refers to it as the ‘Bandwagon Effect’, and prides his success on largely resisting this urge. He famously said to be “fearful when others are greedy and greedy when others are fearful”.

There’s countless opinions on this and some would reasonably argue that you can’t simply spend your investment life trying to always do the opposite of everyone else. That seems exhausting to try and conquer as an individual investor that’s not a billionaire.

So why not simply ignore the human traits all together and follow the data?

Data, after all, doesn’t get emotional.

What else should we watch out for?

So far we’ve covered Loss Aversion and Hindsight, and with part 3 now complete, we’re on the home stretch with just one to go - Familiarity.

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