The Herding Instinct, and why it can trample your returns

In the 1950s psychologist Solomon Asch set up a series of experiments to measure how much a person is persuaded by a majority group. Each experiment had seven people, of which six were actors, and one person was the unaware subject.

The task was simple. The group were first shown a picture of a black line, and then shown a second picture of three black lines of different lengths. The task was to match the size of the original black line, with the correct sized line in the second picture.

The group were then asked to give their answers out loud in a pre-determined order, with the unaware subject, the 2^nd last to give their answer. To some questions the actors gave the right answers, and to other questions they purposely gave the wrong answers. The experimenter wanted to see how the subject responded when all the actors gave the same wrong answer.

After testing 50 subjects with 18 trials per group, the results were startling. When wrong answers were given by the group, around a third of the subjects mostly conformed and gave the same wrong answers. Overall, 75% of the subjects conformed with the group at least once, and 25% of subjects never conformed at all.

Asch’s experiments showed the existence of the herding instinct, which is also arguably the biggest bias in investing. When markets are booming, there’s a tendency to follow the herd and buy, and usually at elevated prices. And when the market is falling, there’s the same tendency to follow the herd and sell, and usually at low prices.

So why do we do this?

The main reason is that the herding instinct is a survival instinct. In prehistoric times, running when everyone else was running, could save a person from becoming a predator’s lunch, as there was safety in numbers.

In short, the herding instinct is natural, but even becomes stronger when a person is fearful, or a situation is viewed by that person as ambiguous.

The herding instinct though, is precisely what we want to avoid when it comes to investing, as it usually means buying or selling at exactly the wrong times.

When markets are falling, people can become fearful, lose confidence, and doubt their analysis. The news cycle doesn’t help either, as falling markets create headlines that cause people to fear even more. Eventually it can become too much for some, and they sell.

There are also additional reasons why selling can be extreme in falling markets. This includes selling due to margin calls, selling by short-sellers, and selling due to unexpected profit downgrades.

As an investor, it’s vital to not bow out of the market at the worst possible time as this will mean not participating in the next uptrend. History shows us that markets always return to new highs at some point. In fact, Australian equity returns (i.e. the sum of capital growth and dividends) have averaged around 10% per annum over the past 100 years.

So why is it difficult to ‘buy low and sell high’? The reason is that to do so requires us to work against our natural inbuilt herding instinct.

Though the herding instinct is strong, it can still be beaten. Here are five ways:

1. Understand that the market oscillates between extremes, from greed to fear, and at some point, back to greed again.
2. Remember that price and value are two different concepts. The real value of a business is its underlying intrinsic value, not its price. Eventually price will follow value.
3. Reflect on your long-term investment goals and remind yourself why you bought into the stock or fund in the first place.
4. Trust your analysis and be patient. Spend time re-examining your investments to confirm that the long-term fundamentals are still in place.
5. Rather than selling, think about buying. Falling markets can provide great opportunities to buy quality stocks at cheap prices. But always ensure the stocks are bought at healthy discounts to intrinsic value.