A TYPICAL investor’s decision is usually influenced heavily by the actions of his relatives and acquaintances. Now what will happen if everybody is investing in a particular stock? The tendency would be to follow suit. This strategy is bound to backfire in the long run. If you want to invest in the stock market, then the herd mentality needs to be avoided.
There are a couple of reasons why a herd mentality operates in such situations. The first one would be acceptance in a group. Most people have a natural desire to be accepted in a group as they don’t want be left out. They would rather be in the group than be branded as an outlier. Adopting the group’s behaviour is an ideal way to become a member. The second reason is common rationale that a large group or collective group of people is unlikely to go wrong. This situation arises when an individual has little experience. Even experienced people are influenced by a group of people suggesting otherwise.
While it’s tempting to follow newest or hottest investment trends, an investor is better off steering clear of the herd. It is not necessary that just because everyone is jumping into certain investments, that investment is correct. The soundest advice is to always do your own homework before following any trend.
What happens when everybody is rushing to buy a stock? There would be a bubble in that stock followed by a crash and then most of the investors would get their fingers burned. A particular investment favoured by the herd easily becomes overvalued as investments of high values are based on optimism, specific good news of the company and not on underlying fundamentals.
Another disadvantage is that a herd mentality keeps you out of market bottoms. Herd mentality prevents you from buying at the bottom as panic is there in the market and most of the investors
are stating that market will crash more. But it’s the smart investors who start buying and ultimately the herd investors play catch up when market starts going up. The herd mentality will also prevent you from getting out before the market peaks.
It’s true that emotions and not logic rule the average investor’s decision making. History suggests that large groups can be wrong but we refuse to believe it. Again, remember that if people in hordes are buying, then there must be someone who is selling. It’s the smart investors who are selling when herds are buying and getting into a trap. I fervently believe in a saying by Warren Buffet, the world’s greatest investor: “Be fearful when others are greedy, and be greedy when others are fearful.”
The writer, Dhruv Desai is director & COO, Tradebulls Securities