Finance

What is herd behaviour in investing and why should you avoid it?

The fear of missing out compels us to mimic the behaviour of other people. It is human nature to follow the crowd. This mentality of imitating others’ actions and behaviour is known as herd mentality. Financial management requires rigorous analysis and research, but in this fast-paced world, not everyone has the time to research to make sound investment decisions. However, we all want to grow our money. Stock market is one popular avenue where investors generally tend to take actions based on what others are doing.

Behavioural finance suggests that investors copy others’ actions out of fear, panic, and uncertainty, especially during stressful times, thus resulting in herd mentality investing. Another driving force behind crowd mentality is our inclination to look for leadership in the crowd.

Herd investing may look like an easy option to lean toward. But there are ways to avoid loss-making investments based on some random person’s decision.

Herd behaviour could adversely affect your corpus:

  1. By following the crowd, you make decisions based on their financial advice without doing your own research. This irrational exuberance can lead to unstable asset bubbles that ultimately pop in the future.
  2. The herd mentality has more potential risk than potential gain. It is not time-sensitive; it often gets too late to get out of the spiral created by this mentality.
  3. There are times you might enter an investment by following others, but you could face challenges at the time of getting out. When other investors start dumping an investment, its value drastically falls. Unless you get out of it at an appropriate time, you are putting yourself in a position where you could lose your money.
  4. Constantly selling and buying investments that are not based on sound research and decision making may result in additional transactional cost, which might be more than the little profit you would be making from that investment.
  5. It is nothing but a poor strategy because it rips you off from your ability to make rational decisions and being an informed investor.
  6. Many times, it’s a trap where people following the herd mentality dump their money in one particular investment, making it overvalued. Post the prices are driven up, insiders withdraw their money and uninformed people are left with nothing but falling share prices.
  7. When you make decisions influenced by others without doing your own research, you are not making decisions based on facts.
  8. We have seen ample examples in the share market where people have lost money by making uninformed decisions based on hearsay. One should learn from those and refrain from making any decision which might lead to loss in future.

Herd behaviour does have some positives when it comes to investing in different avenues like mutual funds, stocks, deposits etc. For instance, it allows newbies to benefit from the research and due diligence of others. Passive index investing is quite common among investors. But, if you look at the larger picture, it has resulted in more losses than gains. You should do your own proper analysis and research before deciding to follow the crowd.

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