Rosalind Evans
Navigating the Pitfalls of Herd Mentality in Investments
Investing can be daunting, especially with $10,000 at stake. How should you decide where to invest? While there’s no definitive answer, many investors make the mistake of following the herd, influenced by cognitive shortcuts and common biases. These pitfalls can be avoided with strategic approaches.
The Bias of Today’s Market Performance
In 2024, the S&P 500 Communication Services index thrived following a 56% gain in 2023, outperforming the S&P 500 Information Technology index. Both tech-heavy sectors have outshone the broader S&P 500 this year, driven by the booming artificial intelligence (AI) revolution and high demand for semiconductor chips.
Some investors see this as a reason to focus solely on tech investments. However, others argue for a diversified approach, considering smaller and middle-sized companies and other market sectors. As some investors put it, “the broader market makes more sense now,” and “it’s finally time for the broader market to catch up with these high-flying sectors.”
Reversion to the Mean
Eugene Fama, a 2013 Nobel prize winner, championed the concept of mean reversion within the Efficient Market Hypothesis. Mean reversion suggests that market prices and returns eventually return to their historical averages. Essentially, what goes up must come down, and vice versa. This principle warns against market timing due to the unpredictability of reversions.
An example is in 401(k) mutual fund allocations, where inexperienced investors often choose funds that have performed well recently, expecting continued gains. Unfortunately, these “What’s Already Done Well” strategies usually lead to disappointing results as once-hot funds excellent and ignored ones pick up pace. Investors learn that past performance doesn’t guarantee future success.
Cognitive Shortcuts
Most investors aren’t financial experts, leading to reliance on heuristics or cognitive shortcuts for decision-making. While heuristics simplify decisions, they can introduce bias. For instance, selecting recently prosperous funds as shortcuts can lead to poor investment choices.
Recency Bias
Recency bias, the tendency to overemphasize recent events, affects investors who prioritize short-term performance over long-term averages. While short-term gains seem attractive, this bias often leads to herd behavior. Economist John Maynard Keynes noted that people might follow the crowd due to perceived ignorance, causing market instability and speculative episodes like the dot-com bubble.
Confirmation Bias
Confirmation bias involves seeking information that supports existing beliefs. For example, investors who are convinced that semiconductors are the new gold might focus only on opinions that reinforce this belief. This bias can lead to unbalanced investment choices based on short-term winning streaks rather than long-term trends.
Rebalancing the Bottom Line
The temptation to abandon non-tech equities is strong. However, market history suggests a likely mean reversion, making other sectors potentially profitable. Rebalancing—selling outperforming sectors and reinvesting in underperforming ones—can maintain a balanced equity allocation. This strategy counteracts the impulse to chase recent winners, promoting disciplined, long-term investing.
While the exact impact of rebalancing on overall returns is hard to quantify, it helps spread risk and capitalize on market inefficiencies. For example, rebalancing tech stocks with utilities or considering stocks vs. bonds can maintain portfolio symmetry and exploit undervalued sectors.
The urge to follow the herd is natural but only sometimes productive for investing. Rebalancing encourages a well-diversified, balanced portfolio, contributing to successful long-term investments and happy retirements.
