The effects of herding bias on investing.
Biases are the filters through which we make decisions about everything—from what movies we watch, to what we have for lunch, to what we do with our money. All thoughts are filtered this way. In fact, it's impossible to make a purely unbiased decision.
What is herding bias?
Herding bias is the tendency to copy the behavior of others instead of making independent decisions. But when it comes to money matters, it can cause us to take unnecessary risks and skip due diligence. By taking the easier route of going with the flow, you may skip the research and analysis that are vital elements of successful investing for the long term.
The problem: Herding bias can lead you to ignore fundamentals in favor of groupthink.
Herding bias is often a root cause of market bubbles. The dot-com bubble of the late 1990s and early 2000s partly occurred because people paid so much attention to the soaring prices of internet stocks that they drew more investors into the frenzy, giving the tech-heavy NASDAQ a wild rise followed by a crash.1
Herding bias plays into the human instinct to conform or blend in with the rest of the crowd. But this can damage your portfolio performance in the long term.
Panic buying and selling are common when investors see that other people are jumping on an asset or rushing to get out of it. For example, the S&P 500® Index dropped by 31% in just one month in early 2020, as investors panicked at the beginning of the COVID-19 pandemic.2 Many people sold at those lows and missed out when the market rebounded.
Researchers at the University of Leeds found that when just 5% of a crowd seems to know where it is going, the other 95% of people will follow along without realizing they are copying the informed group.3
Keep biases in check by working with a Schwab investment professional.
A Schwab investment professional can be a sounding board for your investing goals and decisions, working with you to overcome any emotional or cognitive biases you may have. We can work with you on your terms, whether it's building a one-time plan, providing ongoing support, or introducing you to new products and solutions.
4 ways to remedy herding bias.
-
Know what you're buying and why.
Make sure your decisions fit your long-term goals. Do you understand what role each investment plays in your portfolio? Are you holding on to investments for too long? Have a structure in place so you understand why, when, and how your portfolio is evolving.
-
Stay clear of financial and social media.
The financial media tend to focus on dramatic short-term ups and downs in the market rather than on longer-term performance trends. Staying clear of the financial news can help keep you from reacting to recent news that may lead you to make harmful short-term decisions.
-
Have a plan for volatility.
Biases can lead to ill-informed decisions. Partner with an investment professional to make a plan, agreeing to wait a set period before acting during periods of market volatility or after receiving negative news. You can also schedule periodic portfolio reviews to check your progress compared to your long-term goals.
-
Connect with your driving force.
Why are you investing in the first place? For the future well-being of your loved ones? To champion a cause? Investing success is not just about money; it's about what the money represents. Understanding what it means to you could help foster more rational investing behaviors.
Know what you're buying and why.
Make sure your decisions fit your long-term goals. Do you understand what role each investment plays in your portfolio? Are you holding on to investments for too long? Have a structure in place so you understand why, when, and how your portfolio is evolving.
Stay clear of financial and social media.
The financial media tend to focus on dramatic short-term ups and downs in the market rather than on longer-term performance trends. Staying clear of the financial news can help keep you from reacting to recent news that may lead you to make harmful short-term decisions.
Have a plan for volatility.
Biases can lead to ill-informed decisions. Partner with an investment professional to make a plan, agreeing to wait a set period before acting during periods of market volatility or after receiving negative news. You can also schedule periodic portfolio reviews to check your progress compared to your long-term goals.
Connect with your driving force.
Why are you investing in the first place? For the future well-being of your loved ones? To champion a cause? Investing success is not just about money; it's about what the money represents. Understanding what it means to you could help foster more rational investing behaviors.
Put your new insights into action with either managed or self-directed solutions.
Learn even more on our behavioral finance podcast.
Choiceology®
Wharton professor Katy Milkman shares true stories involving high-stakes moments and explores the latest research to help you make better judgments and avoid costly mistakes.
