As humans, we rely on social proof and the opinions of others. Whether we are buying a new car, searching for a plumber, or looking for a new restaurant to try, most people will look for recommendations rather than objectively analysing the data. This is a natural bias which tells us that if other people like a product, it must be worth trying.
There are some situations where following the herd is logical – for example, if a restaurant in a busy city centre in empty on a Saturday night, there is probably a good reason. But when it comes to investing, giving in to bias and doing what everyone else is doing does not usually yield the best results.
A Short Guide to Investor Biases
Most of us like to think we make rational decisions when it comes to investing. But in reality, we all have biases, whether we realise it or not. Identifying and overcoming these biases can help you to make decisions based on the evidence, rather than emotion.
Some of the main investor biases are:
- Confirmation bias – seeking out evidence that confirms beliefs you already hold. For example, looking at the periods where a fund manager beat the market and ignoring periods of underperformance.
- Overconfidence bias – overestimating our own skills and abilities. Many investors believe they can beat the market average, when this is statistically almost impossible over the longer term.
- Loss aversion – feeling the pain of losses more than the achievement of gains. This can lead some investors to try and avoid risk when they invest, not realising that by reducing risk in some areas, they increase it in others. For example, if you hold your money in cash, you don’t need to worry if the market falls, but your pot will eventually be eroded by inflation.
- Herd mentality – as outlined above, this is the belief that if other people are buying and recommending an investment, it must be worthwhile.
What Happens When You Follow the Herd?
The main problem with following the herd is the issue of supply and demand. The more people want to buy a product or a share, the higher the price will rise. As we have seen in the last few years, high demand and a finite supply of products can lead to shortages and spiraling prices. Eventually, prices settle at a point the market can sustain.
Investor sentiment is a key driver of share prices. Initially, a company might rise in value because it is profitable, has strong cashflow, and holds advantages over its competitors. But as the price gains momentum, more people will invest, pushing the price up further. This can result in a ‘bubble,’ where the price is artificially inflated and has nothing to do with the intrinsic value of the company. Eventually, the price will correct, and the bubble will burst.
This happened on a large scale in the early 2000s as the market crashed following the tech boom. It has happened on a smaller scale on many occasions since – for example, the rise of GameStop following aggressive social media campaigns. Despite the share price multiplying in 2021, it has since returned to more normal levels.
The winners in these scenarios are the investors who bought in early and sold their shares before the crash. Unfortunately, following the herd usually means buying in when the price is inflated and selling when the downturn is already underway.
When too many investors sell an investment at once, this can damage the share price and cause the company to become undervalued – at which point the cycle may start again.
If you invest in shares based on advertising, endorsements, or historical performance, these are all variations of following the herd. There is a good chance that it will already be too late to benefit.
What Should You Do Instead?
We can’t switch off our biases altogether – people are not robots. But by following evidence-based strategies, we can reduce the impact of biases on our investments.
To invest successfully:
- Invest in a wide range of assets from across the whole market. This includes a selection of asset classes, world regions, and company types.
- Avoid increasing concentration in one area, even if you think a particular company will do well. As markets are efficient, any data in the public domain is already priced in. Buying more will simply increase your exposure if things go wrong.
- Take an appropriate amount of risk depending on your circumstances and goals.
- Avoid trying to time the market, as it’s nearly impossible to get right.
- Don’t be tempted to buy more shares when the market is rising, or to sell during a downturn. This can impact your returns and will be difficult to recover from.
- Control what you can, including costs, tax-efficiency, and keeping your discipline.
If you would like objective advice on your investments and someone to hold you accountable for making good decisions, you may want to speak to a financial adviser.
Please don’t hesitate to contact a member of the team to find out more about investing.
The value of your investments can go down as well as up, so you could get back less than you invested.
The content in this article was correct on 26/06/2023.
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