Fighting the urge to follow the herd
By Nick Armet, 28 August 2008
Anyone investing in stock markets over the past five years will know commodity stocks have performed well. However, those who invested more recently may have been witness only to the final frantic rally in these stocks; a rally that somewhat inevitably gave way to the bear market which already had most other equity sectors in its grasp. Investors may be wondering how such unbounded optimism so quickly turned to outright fear.
Markets, after all, are meant to be efficient beasts, where investors have access to all information and act rationally; where overvalued stocks quickly correct in price in response to reduced demand. This principle of efficient markets was put forward by Eugene Fama and held sway for many years. However, critics argue that it fails to explain the bubbles and panics that seem to blight markets and a range of other irrational investor actions that behavioural finance experts call heuristics. Heuritsics are the ‘rules of thumb’ or biases that human beings are prone to use in their decision-making.
A relatively new field in economics, behavioural finance, uses heuristics to explain the irrational behaviour of investors and, in turn, those episodes when prices move away from fair value. Over the long term, most analysts are agreed that fundamental factors such as company valuations drive share prices. However, in the short term, other factors such as liquidity, technical factors and investor behaviour can all have a pronounced effect.
Perhaps if we know the biases that we are prone to as investors, we can avoid them in future? Here are some of the most common:
Herding
This is when investors blindly follow the actions of others without any real investigation of their own. ‘Jumping on the bandwagon’ is a shortcut that feels comfortable because there's a large number of people doing it. An individual may also assume others in the crowd have access to ‘hard to find’ information. Interestingly, in the event of a loss, this approach removes some of the blame from the individual as he was acting with others. In the event of a gain, however, one could safely assume he would congratulate himself for a great decision that could be shared at many dinner parties. Following the herd is not always wrong, of course. However, the later an investor follows, the greater the risk. During the final days of the ‘dot.com’ bubble, investors who got in late to the party found the drinks were still flowing, but the tablecloth was whipped away just as they got seated.
Representativeness
This is when a small sample size of available data is wrongly assumed to be indicative of a much wider sample. Or the reason opinion polls are so often wrong! It can also come through in our tendency to use limited experiences to substantiate larger themes. In investment, it could mean assuming any company in a ‘hot’ sector is a good buy just because there are other good perfoming stocks in that sector.
Frame dependence
This is where an investor makes a poor decision based on how they frame the issue. For instance, it can help to explain why an investor does not sell a stock that is showing a loss. The investor is emotionally attached to the stock and has sunk a cost in its purchase. The desire to avoid regret and have their decision proven right means the investor is unable to sell at a loss even if the outlook has materially worsened.
Confirmation bias
This is where the inability to take a loss is further hampered by an investor’s tendency to look only for confirmation of their initial decision. Those factors that confirm the decision to buy are given extra weight while any piece of news or data that supports selling is ignored.
Self Deception
This is when an investor has a strong view on something, so much so that, he is unwilling to change or modify the view even when faced with mounting evidence to the contrary. It is often associated with self-attribution, where good decisions are put down to skill and bad outcomes to bad luck. Rogue traders, such as Nick Leeson who brought down Barings with bad trades, may well have suffered from both these biases!
Anchoring
This is when certain historic price levels are given undue prominence in an investor’s mind. Even professional analysts can fall into this trap – company earnings forecasts tend to be anchored on the previous year for example and may not take account of a recently changed operating environment.
These are just some of the biases the behavioural finance gurus think we are prone to. So what can we do about it? Well, it might not be possible to change the way we think, but recognising that we are prone to these mistakes allows us to learn from them.
Fight the urge to follow the herd, for instance, particularly if you are getting in late to the party. One of the most common mistakes an investor can make is to buy into markets or sectors when they are high and the mood is most optimistic, only to sell out when prices are falling and the outlook is uncertain. Investing in a diversified portfolio of stocks is one thing; having the nerve to hold on or even to invest against the flow may be more difficult but ultimately more rewarding.
