19th January 2015 at 3:13pm
Why is it that we buy or do what everyone else is buying or doing? Behavioural psychologists would argue it’s down to herding behaviour. It’s not just the animal world which is prone to forming a herd; we humans like to follow one too.
Herding involves instinctively following the actions of others, instead of seeking out for ourselves the information we need to make our own decisions. This herding behaviour can be quite harmless and we’re probably not even aware how we’re behaving, or the effect our actions can have on others.
I’ll have what they are having
Let’s take an example. You and a friend are walking down a street and looking for somewhere to have dinner. There are two restaurants on the street and both look equally appealing but it’s early evening and both are empty; so you choose restaurant A, for no particular reason. Soon, a couple walks down the street with a similar thought in mind. They see you sitting in restaurant A while B is empty, and choose A on the assumption that as it has customers it is more likely to be the better choice. As others pass-by during the evening and choose the by now much busier venue, restaurant A does a lot more business that night than B.
Thanks to that first random act of choosing one eating place over another we’ve created a crowd and a roaring trade for restaurant A, based on no prior knowledge and nothing more than thinking it looked like a nice option.
It’s a trend that’s not gone unnoticed by catering managers. When you go into a restaurant you are likely to be guided with much pomp and ceremony to the best seat in the house –from their perspective – at the table near the front window where you’ll be easily spotted by passers-by.
Herd it through the grapevine
Sometimes the collective wisdom of a crowd can be surprising. In James Surowiecki’s 2005 book ‘The Wisdom of Crowd’, he recorded an example witnessed by Francis Galton, Darwin’s cousin, in 1907 where the average of all the entries in a guess the weight of the ox competition at a country fair was amazingly accurate. The average figure even beat the guesses of cattle experts, leading Galton to believe that the average judgement of the crowd can converge on the right solution.
He did, however, emphasise that one requirement for a good crowd judgement is that people’s decisions are independent of one another. If everyone let themselves be influenced by each other’s guesses, there’s more chance that the guesses will drift off course
Beware of Black Friday
However when it comes to investing in the stock market such behaviour can be very negative. How many times have we seen blind faith in market trends by a swarm of individuals lead to frenzied buying (bubbles) and selling (crashes). The stock market crash of the 20’s and the dot-com bubble of the noughties are classic examples.
Major stock market trends usually begin and end with these bubbles and crashes and many observers cite these episodes as clear examples of herding behavior that is driven by emotion, not rational thinking. Over excitement takes control in the face of financial gains in the bubbles, fear in the crashes. Individual investors join the crowd of others in a rush to get in or out of the market.
It pays to keep your cool
It’s very easy to lose your cool when investing, and worry or panic when you see the value of your investments, including your pension funds, fall and other investors dropping out of the market. When this happens, it’s quite likely you’ll be hugely tempted to follow the pack and sell, sell, sell with a view to keeping the money somewhere ‘safer’. But if you do, it means you’re likely to be selling after markets have already fallen – and crucially, before they might rise again. That means you lock in your loss.
So although it’s tempting to take your money out when markets fall or you see others jump ship, it’s not normally a good idea. You run the risk of missing the rebound, and potentially could have less money than someone who kept their composure.
Alternatively you might see markets doing really well and people jumping on a stock market bubble bandwagon. You get excited, and want to buy in to them. But if you do that, you could end up buying at the top of the market and might just see your new investment fall soon after you buy it – euphoria quickly turns to anxiety.
Respond, don’t react
So, what should you do when you see your investments fall? Responding to events is fine – it’s worth checking your investments to make sure that what you’re invested in is still appropriate for your goals and your circumstances. And make sure you spread your risk so that you don’t have all your eggs in the one basket.
Just be sure you’re making any changes for the right reasons and don’t react out of panic as you see others sell. When markets are rocky take some deep breaths, try to keep your composure, and focus on the long term.
Look before you leap
It’s interesting to see a great deal of faith still seems to lie with the judgement of the crowd and how our actions are often dictated by those of our peers. Whilst there’s no denying there can be a certain safety in numbers, caution and vigilance should always be taken before you decide to run with the herd.
Read more about how our emotions affect our savings behaviour on our website.
A Stocks and Shares ISA and a pension are investments. The value of investments can go up or down and may be worth less than you paid in.
Past performance is not a reliable indicator of future performance.