Watch for Herd Mentality
TO ERR IS HUMAN
Most consider humans to be the ultimate species on earth and in spite of that, they have a tendency to let their minds get the best of them whether it be ego, fear, greed, overcompensation, and the list goes on. One thing that makes humans human is their ability to adapt based on what they learn. In the uncertain world of finance, it is important for us as humans to realize that we all make mistakes and will continue to make mistakes. We are not perfect but we can train our minds and bodies to adapt in order to increase our chances of success. When it comes time to making decisions, we tend to think we are always using logic, but that is not the case!
The human mind is the most powerful and critical part of the human body. Without it our bodies cannot function. It only makes sense that the mind needs to be equipped for any and all situations that we face in life. Anticipating the environment around us and planning ahead is what will make the biggest difference towards leading a successful life. Particularly for investment decisions, it is important for us to know when we quit our logic and make decisions based on emotions. A cognitive bias is when an error in judgement is made because someone makes a decision based on emotion or personal beliefs rather than facts. There are many biases which we can succumb to and make poor decisions. Here we will bring awareness to the reality that all humans have some level of bias. And while it is not always possible to eliminate them completely there are steps to take to identify when biases are clouding judgement and how to adjust for them.
In his book, Thinking Fast and Slow, Daniel Kahneman takes the reader through a journey within their minds and explains how these cognitive biases come about.
We will explore one of them below:
Herd Mentality
Imagine you are watching a movie in a theatre. All of a sudden you hear the fire alarm blare and the audience starts rushing in one direction? What do you do?
Of course, you follow the crowd and do exactly what others are doing until you can assess the situation on your own.
Some investors are prone to this herd mentality. They follow what other famous investors are saying blindly. They have no judgement of their own and do no analysis for themselves. They are purely driven by emotion.
The legendary investors are famous mostly because they know their stuff. They most likely did their research, learned from the markets and learned from their past mistakes. But an investor cannot just blindly follow the legends and invest in anything without analyzing it beforehand.
The key takeaway here is that the most important thing an individual can do before investing is learning everything they can about whatever they want to invest in. The stock market is an ever-changing place. Powerful contenders can one day be at the top and the next day that is all changed and they could even be gone. Nothing is promised in life. Do not just go along with the rest of the herd like a robot. Do the research and invest in what you can understand and comprehend. There is no need to follow the hype as no one knows if it will hold up.
Legendary investor, Warren Buffett, is well known for his contrarian stock picks. He says he keeps three piles of research, one for the stocks that he likes, one for the stocks he is certain he will not pick and the third one is the "too hard" pile. This is the pile where he would put a stock if he is not confident he can analyze and understand the stock. This shows the humility required to be successful at something inherently risky - even for this most successful investor!