Herd and illusory superiority bias: Why even seasoned investors succumb
The herd bias phenomenon or the ‘bandwagon effect’ will be familiar to most long-time investors. It leads people to make investment decisions based on the belief that ‘everyone’s doing it’.
This type of behaviour is part of human nature, though, in the context of markets, it is usually associated with novice retail investors who aren’t confident in their decision-making and thus resort to panic-buying or selling.
For example, recent high-profile surges in the price of GameStop shares and the dogecoin cryptocurrency, among others, seem at odds with fundamental analysis and so are commonly attributed to the herd mentality. The same can be said of the dot-com bubble around the turn of the millennium.
When the prices of overbought assets suddenly crash, pundits often view it as confirmation of the prevailing wisdom that the herd is always wrong. And yet, in the cases of GameStop and dogecoin, Robinhood traders on the Robinhood platform weren’t the only ones driving demand for these assets. Veteran traders and institutional investors were part of the stampede. Many of them made money and some got burned.
Surely these market participants — with their sophisticated algorithms and years of investing experience — didn’t succumb to a herd mentality. So why did they join the herd? As the old saying goes: ‘It ain’t what you don’t know that gets you into trouble, it is what you know for sure that just ain’t so’.
The irony is that most decisions fall in line with the average investor’s decision. That’s just how averages work. If enough people believe their assessment of a situation is superior (when it’s really just average), the herd forms.