Herd of this trend?

In the second part of the series on investor psychology, we consider why herd behaviour can make you lose, rather than gain, money.

Chandralekha Mukerji | Print Edition: October 2010

Suppose you are returning from a late-night party in an unfamiliar part of the city and encounter a road blockade. Even as you are forced to take a diversion through an isolated stretch, you find most vehicles going towards the right, whereas your own sense of direction urges you to take a left. What do you do?

In all probability, you'll avoid taking a risk, discard your own choice and go with the cavalcade. What you are indulging in is herd behaviour.

While this behaviour pattern surfaces regularly in day-to-day situations, it comes into high focus in financial markets. Behavioural finance explains herd behaviour as the inclination of individuals to ape the actions, rational or irrational, of the majority.

According to British economist John Maynard Keynes, in an unpredictable situation, investors are reluctant to act as per their own information and beliefs because, if they go wrong, their contrarian behaviour is likely to damage their reputation as sensible decision-makers.

There are other reasons why people act in this manner. One is the social pressure of conformity, which forces them to be a part of a group rather than being isolated. Besides, most investors tend to believe that others know more than them or have information that they don't.

Hence, following the majority gives them a sense of security. This concept challenges the basic tenets of the classic economic theory, which proposes that investments are an individual's rationally formed decision using all available information.

The most visible outcomes of such behaviour in the market are bubble formation, or a boom, and the subsequent bust. Remember the infamous dotcom bubble in 2000? Or the Orchid Chemicals and Pharmaceuticals case, where the company's stock lost over 45 per cent in two days in March 2008 even though, essentially, nothing was wrong with the firm?

More recently, everybody went on a gold-buying spree just because it was in vogue. Many who invested in the precious metal were probably not aware that the prescribed allocation to gold in a portfolio is 10-15 per cent. All these were actions resulting from herd behaviour, which leads to two disastrous investment errors-hype buying and selling.

What the typical flock investor doesn't realise is that it's important to enter the market at the right time. One needs to ensure that he catches the trend at its beginning. By the time a herd investor finds out about the latest buy, the smart, well-informed investor has already taken advantage of the news and exited it at its peak.

But as more and more people rush to pick the stock, it becomes overvalued and is subject to a correction. So when the swarm buyer enters, he is more likely to lose money than gain as his decision is usually based on optimism and ignores the underlying fundamentals.

What the investor also forgets is that the frequent buying and selling in a bid to catch a trend results in high transaction costs, which eat into his profit.

Such is the pull of the herd that even fund managers are tempted to follow the investment decisions of other professionals. If the trick works, his clients are happy and, if it doesn't, he defends it by citing similar misjudgement by others.

Even though it's tempting to catch a trend that promises good returns, an investor must do his homework and gather strategic information before joining the herd.

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