Should I Follow the Crowd?

When you see “everybody” buying or selling their shares, don’t tell us you aren’t even a little bit tempted to follow suit. After all, all those people can’t be wrong — or can they?

Spiking wants to help you become a better-informed investor — the kind who makes decisions based on verified, real-time information. This means not deciding to buy or sell based on rumour, or just because “everyone else is doing it”. To this end, Spiking provides you with data coverage from the Singapore Exchange and nine other exchanges across the region.

We’ve also compiled some industry experts’ answers to the question, “Should I follow my instincts, or just jump on the investment bandwagon?” New investors might want to pay special attention, while seasoned investors might want to see if they agree.

Running With the Herd

Writing about behavioural finance, Egharevba Etinosa, who is an operations head at LAPO Microfinance Bank Limited, recognises the impact that psychological factors have on financial decisions. He mentions a theory of finance that observes that investors make decisions based on imprecise impressions and beliefs, instead of rational analyses.

Mr. Etinosa goes on to explain that behavioural finance studies the different psychological biases that people have, citing the herd instinct as a prominent bias. The herd instinct causes people to follow popular trends (which Spiking has discussed in a previous post: https://spiking.com/blog/making-sense-stock-market-trends-2/) without really thinking about why. This instinct is infamous for causing rallies and sell-offs in the stock market.

Lorna Tan, Invest Editor and Senior Correspondent at the Straits Times, also mentions herd instinct in her article on the “investment roller coaster”. She likewise cites behavioural finance studies showing how, goaded by fear and greed, investors allow themselves to be led by the actions of the majority and jump on the bandwagon.

Miss Tan says investors should ask themselves whether they tend to react to market noise. Investors need to bear in mind that markets are driven not just by fundamentals but by investing behaviour, which doesn’t always make sense. Knowing this, investors should do their best to change, and take steps such as reviewing their diversified portfolios regularly, or getting help from a financial adviser.

Going Against the Flow

Seraf Co-Founder, Christopher Mirabile writes about bandwagoning in relation to angel investing. He points out that momentum causes tremendous peer pressure, i.e. “Everyone’s investing; so I guess I should, too.” Investors run the risk of getting a raw deal or making a not-so-smart investment if they decide to buy because of the bandwagon effect.

But Mr. Mirabile says the real risk of bandwagoning lies in missing out on great investment opportunities that the majority, or the herd, has overlooked. This happens because these opportunities might seem unattractive, illogical or just plain “crazy” at the outset — it’s only later on when the real potential of these investments comes to light.

In terms of angel investing, an example of these investment opportunities might be a start-up developing new technology. The real challenge lies in figuring out whether a potential investment really is a diamond in the rough or not worth your investment at all.

No less challenging is jumping off the bandwagon to give that start-up a chance. Others might think you’re as crazy as the opportunity you’re investing in. This is not so easily ignored, especially if those others are several experienced, intelligent investors. If they’re not investing in this stock, there must be a very good reason.

If you feel very strongly about a certain investment opportunity that is being ignored by most other investors, you can either go with the flow, or stick to your guns. If you’re leaning toward the latter, try to keep an open mind and find out why you think that start-up is a good investment. If your faith proves unshakable, then be prepared to stand your ground — whether other investors follow your lead or not.

Crowds Aren’t Always Correct

When hanging out with a group of friends, it’s only natural to want to fit in. If you all happen to be stock market investors, you can discuss your trades and your favourite stocks using the Spiking app chat function. But if you see that they’re all buying the same stock or are in a hurry to get rid of their shares, stop and think for a moment. Just because a lot of people are doing something, doesn’t make that something right.

Wealth Horizon says as much, noting how the “safety in numbers” concept is a favourite among investors, particularly those who don’t have much investing experience. “They must know something I don’t” is a familiar thought, as is “I don’t want to be the only one to miss out.” This is how hordes of investors end up putting their money into the same stocks, which in turn often creates stock market bubbles (which Spiking has discussed in a previous post: https://spiking.com/blog/investing-bubble/).

That said, Wealth Horizon says investors are better off avoiding the herd altogether. To do this, you should figure out how much risk you’re willing take on, and stick to your investment strategy. If you’ve bought or sold stocks following herd instinct, return to your portfolio’s original asset mix.

For his part, Dear Mr. Market advocates understanding the herd instead of following it. Like Mr. Etinosa and Miss Tan, he also refers to behavioural finance and how emotional people can get when making investment decisions. With that, there’s just no sense in jumping on investment bandwagons, especially when there is no historical evidence to support herd mentality as being beneficial to investors.

Mr. Market also points out that following the herd also often results in investors losing money instead — offering the 1990s dot-com bubble and the 2000s real estate bubble as examples. To avoid these kinds of losses, Mr. Market also stresses the importance of having an investment plan to keep you from making decisions based on emotions. This plan should only be adjusted according to changes in your financial situation or your life goals.

When carrying out that plan, investors ought to rebalance their portfolio regularly (like once or twice a year). This means moving against the herd by selling assets whose prices have gone up, and buying those that are less popular — and getting better returns in the process.

What About Following My Instincts?

So if running with the herd isn’t a good idea, should I go with my gut, instead? Werner Grundlehner, writing for UBS last February, says that following your instincts isn’t much better. Referring once again to behavioural finance, Mr. Grundlehner calls human instinct one of the greatest obstacles to an investor’s success on the market.

He also points out that intuition causes investors to fall into traps, and ironically, makes them susceptible to being influenced by others, or by the herd. Citing the latest crisis in China’s stock market, he notes how more and more investors wanted in on the action without really looking at fundamentals. “My friends made lots of money that way, so I’m going to do the same!”

Many investors also lack financial knowledge, which means their intuition might cause them to make flawed decisions. Blinded by potential returns, for instance, they might invest without fully understanding the risks involved. This lack of knowledge also causes them seek investment advice from family or friends, who might not know a whole lot more than than they do, and are also part of the herd.

To guard against going with your gut, Mr. Grundlehner recommends writing an “investment script”, which is an articulated form of a sound investment plan. Like a movie or a TV script, it tells you what to do (or even say, to yourself) in the event of something happening in the stock market that might make you want to follow your instincts instead of rational judgment. “If everyone is buying so-and-so stock, this is what I’m going to do” or “If my shares of so-and-so drop, I will do this.”

He also suggests famous financial psychologist, Joachim Goldberg’s habit of keeping an “investment diary”, where you can write down your reasons for buying or selling certain stocks. By helping you remember the reasons you gave for your sale or purchase during a less emotional moment, the diary can also help you stick to your investment script or plan.

For 100% emotionless and logical investment decisions, Mr. Grundlehner quotes behavioural finance lecturer, Jerome Zaugg, who says investors should use automated systems that are programmed to make rational assessments.

Make Sound Investment Decisions With Spiking

Spiking gives you access to verified, real-time facts, that can help you decide what and when to buy and sell at the stock market. You can find out why a stock spiking on the boards is making waves at the moment, and figure out whether it would make a good addition to your portfolio. You can check out its charts, ratios, social media mentions, news and recent announcements, and even discover who its significant shareholders are.
 
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Sources: 
https://www.linkedin.com/pulse/concept-behavioral-finance-etinosa-aca-acfe-amscce-clrmp-ifrs-cert
https://seraf-investor.com/compass/article/should-i-jump-bandwagon-angel-investing
http://www.straitstimes.com/business/invest/the-investment-roller-coaster
http://www.wealthhorizon.com/dont-be-a-sheep-why-following-the-herd-not-the-best-investment-for-investors/
https://dearmrmarket.com/2014/10/21/understand-the-herddont-follow-it/
https://www.ubs.com/magazines/investing/en/stay-on-course/2016/gut-feeling.html