Following the herd can box you in

Following the herd can box you in

Mercer

Investors often ignore their own information to follow the decisions of other investors – to their own detriment. It’s a phenomenon called “herding” and it can have serious financial implications for investor portfolios, financial markets and the wider economy. So why do we herd?

Many notable researchers, including Sigmund Freud and Wilfred Trotter, have studied the phenomenon, and there is an enormous body of evidence to show herd mentality bias exists.

The reason we herd, it seems, has more to do with social behaviour than how markets operate. As Dr Julie Coultas, psychology research fellow at the University of Sussex in the UK explains, we have evolved to be socially conforming animals simply to survive.

“A conformist tendency would facilitate acceptance into a group and would probably lead to survival if it involved the choice, for instance, between nutrition or poisonous food, based on the copying behaviour of the majority,” Coultas says.

But this copying behaviour isn’t always helpful. For example, some studies suggest that in a dynamic environment, collective decision-making (herding) can lead to inaccuracy with some people too readily influenced by others.

Felt by financial markets

The literature points to herding behaviour as a cause of instability. Herding can cause financial bubbles – when enough investors create a “hive mind” geared for buying, essentially overvaluing a particular stock, asset class or market.

Conversely, when herding investors suspect an economic imbalance, they will often withdraw capital or “fly to safety” by selling and moving their funds into safer asset classes such as gold or government bonds, causing stocks, assets and markets to fall.

This flight-to-safety phenomenon typically occurs during periods of market distress when an unusual event – not necessarily financial in nature – causes panic and triggers fear in the marketplace. History is riddled with examples of market crashes where investors have flown to safety, such as the September 11, 2001 terrorist attacks on New York and the subprime mortgage crisis of 2008.

High cost

Flight to safety may feel like a prudent response to market volatility but the research implies the opposite is true.

A 2016 report by market research firm Dalbar looked at the long-term annualised returns of the average equity mutual-fund investor compared with the S&P 500 over a 20-year period. The study found that investors who bought and sold earned about half (4.6%) of what they would have if they’d bought and held an S&P index fund (8.19%).

Further, researchers have found that a flight to safety forecasts a decline in real economic activity that can have broader and longer lasting implications. A 2018 study focusing on the US economy shows that GDP growth falls by about 1% when there are three flight-to-safety events in a quarter, and by 2.4% when flight days in a quarter rise from zero to 10%.

How to stay put

Mercer senior strategic financial adviser, Ron Smith says getting guidance from an experienced adviser can be a potent method to help investors cut through the noise and stay the course.

Advisers can prepare investors mentally for periods of volatility. The other benefit of working with a good adviser is that investors get specialised financial analysis to help them shut out inaccurate market and media noise.

“Our advisers outsource to experts in each investment sector so clients get a holistic view of the market as it changes and can make informed decisions with real facts,” Smith says. “This gives you a strategy when markets fluctuate as well as the tools to help you stay on track when fear and panic might otherwise take hold.”


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