Behavioural Bias Series: Edition 3 - Herd Mentality
by James Twidale
We continue our recent series of behavioural bias articles. This month we are talking about the “Herd Mentality” which is also known as the “Bandwagon Effect”.
Modern society and thought leaders strive to tell us how unique we all are and how special every individual on this planet is. We are pushed from a young age to see the world from our own vantage point and have our own views on just about everything. An age of independent thinkers is the outcome of this individual freedom.
Yet again our primitive brains tend to put the survival instinct ahead of any more rational views in terms of economics and investing. The reasons our brains default back to survival mode instead of academically rational thought frameworks is a discussion for someone far wiser than I, but the truth is our primitive brain often tends to make suboptimal decisions despite our perceived informed position.
The herd mentality is a great example of this debate. Despite being unique thinkers who all see the world in our own way because we are of course all special, we tend to make the same decisions as the person sitting next to us and across from us. Why?
Perhaps it is because our very survival in the evolution of the human species has been as a result of the fact that there is perceived safety in numbers. Two is greater than one and three is greater than two and so forth. While this strategy worked well when trying to fend off predators in the hunter-gatherer era it is not necessarily optimal to apply this logic in the modern era. I mean, after all, remember you are encouraged to be unique and think independently after all.
As you read this you are probably say something like “obviously, does this guy think I am an idiot” yet when you stand around the braai or chat to your best friend at the local coffee shop and they tell you about the investment they just made into Amazon shares you tend to see more logic in that narrative than may be rational and surely because they have invested in it there is some safety in you investing in it as well. To add to this, Amazon has grown into one of the largest companies in the world, meaning its successful and many other investors tend to agree that it’s a great investment otherwise the share price would be headed in the other direction. In fact, by not investing in Amazon and perhaps investing your money elsewhere you are making the “un-informed” and irrational decision to forgo a good thing. I mean surely if you knew as much as the professional investors and your friend you would simply and logically come to the same conclusion that they all came to.
Now let me point out that I will not attempt to explain the rationale applied by each previous investor into this share, the reasoning applied by each investor is different, maybe the result of another bias and in relation to the above lesson is in fact irrelevant.
For some psychological reason, we come to the conclusion that by following the wisdom of investors A, B and of course our good friend that we are making the correct decision and that we have applied the kind of logic we should have applied if we were to think as independent thinkers in any case.
The fact that investor A may have bought the Amazon share 10 years ago is not factored in, the fact that investor B invested when the price was 15% lower than today and the fact that your friend only bought one share is never discussed or factored in, because this is a proverbial “no brainer” and off you go and invest 10% of your total investable assets into the wonderful Amazon share.
I must point out that the homework and research that you may have done before making your investment may very well have been very comprehensive and thorough. In fact, you may very well have come to the same conclusion in complete isolation. Which, if that’s the case then fantastic because then you have not fallen into this trap. Despite this, there is still some sense of comfort that we gain from knowing that others are doing the same thing we are doing.
This is how bubbles are often caused and how many poor investment decisions get made by both advisors and clients because if others are doing it there must be some correctness in the decision.
For advisors, this trap is often far more prevalent, because they are often judged by the investment proposals they make and their subsequent performance. If an advisor suggests selecting fund A and the fund subsequently underperforms, the client is far less likely to lose faith in the advisor if the fund is managed by the largest fund manager in the country, because there is some safety in the well known and most selected fund manager (this is after all how they become the largest) as opposed to selecting a new and perhaps smaller fund managed by a smaller fund manager.
“Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” – John Maynard Keynes
The result of the herding behaviour for advisors is that their investor’s portfolios have sub-optimal allocations to assets/funds/managers for no other reason than “everyone” else is doing it. This herding mentality is also made easier with subliminal marketing that re-enforces our decision making.
The results of this herding behaviour has lead to over concentrations in portfolios, asset price bubbles and market crashes. Prices don’t drop by themselves you know. There are also other behavioural and fundamental issues that add to this, but herding gives us a sense of comfort that allows us to make these decisions without buyer’s remorse or regret.
Perhaps armed with this information swimming upstream or doing the opposite of what the herd does, in fact, gives us the highest probability of success. In fact, by investing in the biggest share in the world at any point in time over the last 30 years (which by default means the most invested in/selected share) you underperformed the global equity index in the following decade by an average of 10.5% per year. Ouch!
In conclusion, I encourage you to be unique and think independently as both an investor and advisor. You have access to information and the ability to apply this information rationally. If you know more about these biases, the hope is that you can avoid them with a higher level of frequency than you make them. You will no doubt fall into these cognitive traps from time to time but perhaps next time you consider something new or a suggestion from your advisor to allocate to a fund/manager you have not heard of before your default should not be to opt for the popular option.
Market Update - July 2019
by Oratile Tlhabane
Financial markets declined in July, with the JSE All Share Index dropping 2.4% for the month. Resources were unable to continue June’s positive momentum, down 5.2% in July. Growth forecasts for the SA economy were downgraded and an announcement of further funding for Eskom, saw ratings agencies expressing their concern with Fitch changing SA’s credit rating outlook to negative.
Financials dropped 6.4% while Industrials were the only sector to post positive returns last month, up 1.2%. The month of July also saw the South African Reserve Bank (SARB) and the US Federal Reserve reduce interest rates by 25bps to 6.50% and 2.25%, respectively.
Small caps had a slightly positive month, up 0.5% while Mid and Large cap shares were down 2% and 2.6% respectively. SA Listed Property posted a 1.2% loss in July while SA bonds ended the month 0.7% lower.
The MSCI World Index ended the month slightly positive at 0.5% in US Dollar terms while the MSCI Emerging Markets Index ended 1.1% down in US Dollar terms. The US economy added 164,000 jobs in July, which kept the unemployment rate steady at 3.7%. Global Bonds were relatively flat, ending the month 0.3% lower.
The Rand gained 3.3% against the British Pound Sterling and 1.7% against the Euro, while depreciating 0.5% against the US Dollar. The US Dollar Gold price increased by 1.2% while the Brent Crude Oil Price decreased 2.1% in the month of July.
The below graph shows the asset class returns for July (in ZAR):
With markets largely down for July, see below data showing how the average fund in the different ASISA categories performed. Giving an indication of how the average investor’s experience was for the month, all the way through the last 5-Year period reflective of past market conditions:
Multi-Asset portfolios invest in a spread of asset classes including cash, bonds, equities and property both locally and abroad. The SA Multi-Asset Income Category (which is limited to 10% equity exposure) closed ahead of funds with higher equity allocations for the month of June. The category ended the month 0.5% in the positive, while the SA Multi-Asset High Equity Category (with equity exposure up to 75%) ended 1.1% down.