Beware of the Herd Mentality Bias
by Patrick Hoover
One aspect of behavioral finance that is often overlooked is the Herd Mentality Bias. In Peter’s article, he discusses the other biases that impact our behaviors, but as the name implies, this bias refers to a tendency by investors to copy what other investors are doing, allowing emotions to dictate their investment decisions instead of performing their own analysis. This bias is common not only in investing but also in everyday life, and there are countless examples. When choosing between two new restaurants serving the same type of food, most people will choose the restaurant that is full of people rather than the one full of empty tables. In social settings, people often gravitate toward larger groups or groups of popular people. Every year on Black Friday, countless people go into a frenzy seeking discounts on the latest TV or gaming system. This is because humans are hard-wired to herd, making it difficult to go against the crowd.
The problem with herd mentality is that the crowd is not always right. This can be seen from the dot-com bubble of the 90’s, when investors bought into speculative and financially unsafe dot-com companies simply because everyone else was doing it, or following the 2008 housing market crash, when investors began panic selling off their shares, causing stock prices to plummet. In both cases, investors followed the lead of others, causing losses that could have been avoided had they done their due diligence.
If you’ve spent any time catching up on financial news over the past year, chances are you’ve heard of “meme stocks,” which are currently a very hot topic. Although many investors have made money off such stocks, it is important to remember what defines a “meme stock.” A “meme stock” is a stock that has seen a large increase in volume not due to the performance of the company, but rather due to hype on social media or online forums. Often, people buying these stocks have done little to no research and are simply buying into the hype. One such “meme stock” is GameStop and provides a very recent example of the herd mentality bias in the form of the GameStop short squeeze, in which investors, many with little-to-no prior trading experience, began rapidly buying GameStop shares. Although the price of GameStop did skyrocket, and many profited off it, there were also many that lost money due to buying shares simply because they saw that other people had done so or were told to do so by their friends, ending up buying when the stock was at a high point and then losing value when the shares dropped. I, myself, had friends who bought in and were recommending I do the same when the price was already well above $300, and I can attest to just how difficult it is to go against the crowd and not buy the hype. For reference, I’m very glad I did not, as GameStop is currently priced at about $191 per share.
What we’ve seen occurring in the markets lately is a reminder of the importance of doing your own due diligence, and not being blinded by the herd mentality bias that has caused the downfall of many investors. Often, by the time that everyone is investing in something, it is already too late to get in. To quote the famous investor and politician Joseph P. Kennedy, “when even shoeshine boys are giving you stock tips, it’s time to sell.” Next time you feel pressured to invest in the latest “meme stock” or whatever the trend may be, remember to perform your own analysis, and don’t let the herd mentality bias blind you from making a potentially poor decision.