If you ask a behavioral psychologist, humans are like guppies. These tiny fish are known to forage in large schools. An individual guppy only goes where the others go. Humans, too, act like guppies sometimes, especially when it comes to investing in the market.
The herd instinct is a fascinating trait that can be very useful in social situations but has infamously led to several disasters in the financial world. Read on to learn more about what the herd mentality is and how it can ruin your investment portfolio:
Understanding the Herd Instinct
Humans are highly social animals that are accustomed to living in large groups. Groups offer security and opportunity. Therefore, we have a natural instinct that compels us to follow others to gain access to resources. This is the herd instinct in simple terms.
This innate herd instinct can come into play when we invest in risky ventures like stocks. To better understand what’s involved here, consider the analogy of the oilman who goes to heaven. Denied entrance at the Pearly Gates, an oilman begs St. Peter for a second chance. St. Peter caves in and tells the oilman that he can enter heaven only if he can persuade another oilman to go to hell.
Sometime later, St. Peter sees not one, but a long line of oilmen going to hell. When he asks the oilman how he managed to convince all of them to go, the oilman replies coolly, “I told them that there’s oil in hell.” The story doesn’t stop here. The oilman himself joins the group that’s going to hell. When St. Peter asks him why he changed his mind, the oilman replies, “you never know if there really is oil in hell.”
The story is a sharp allegory of the herd mentality. As humans, we prefer to follow the herd because we are passing on individual risk to an entire group. Relying on groupthink in this manner is not without consequences. When the oilman arrives in hell, he’ll find out that there’s no oil there. To an extent, this is what happened when the markets crashed during the dot-com bubble in the nineties and during the 2008 recession.
How Investors become Vulnerable to Herd Mentality
Think about the number of instances someone asked you to buy stocks from or invest in a lucrative venture. You would naturally have been skeptical. But what happens when you see hundreds or even thousands of investors like you rushing to buy those much-desired marijuana stocks, marijuana penny stocks, or bonds?
You would be more than willing to invest in the hype because you fear missing out. You may assume that others have done the research that you haven’t. Here’s the tricky part: that’s exactly what everyone else thinks too.
When you follow the hype in this way, you are incurring unnecessary risk. Scammers are highly adept at exploiting the herd mentality. Instead of joining a group of investors to earn profits, you are more likely to end up with junk bonds or worthless stock.
Avoiding Herd Mentality
Avoiding falling prey to herd mentality isn’t difficult. If you notice people excitedly murmuring about a stock or an asset, stop and think before you fall in line. Do your own research before putting your trust in the crowd. More often than not, your research will reveal that a hyped up stock is only a scam.
There are certain precautionary steps you can take to avoid falling victim to fraud like pump-and-dump schemes that take advantage of this herd mentality. For starters, don’t believe everything you see in chain mails. Find out who really writes those reports that give the impression of being impartial. Get your news from sources trusted within an industry instead of so-called “experts.”
Above all, pay close attention to how a stock or an asset is priced over time. If you see a sudden price escalation, be cautious before investing. Understand exactly why the price went up. More often than not, sudden price escalations without any changes to a company are caused by artificial hype, not actual value.
Being vigilant and conducting proper research should protect you from making unwise decisions. Be aware that it is very easy to get carried away, so prepare yourself when the next hyped asset comes along.