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To follow the herd … or not

Jan 13, 2014 @ 9:33 am

behavioral finance, herd mentality, yes, confirmation bias
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“Try the chicken piccata, it's our most-ordered dish.”

“Consider the Richmond, it's our most popular floor plan.”

Salespeople have long understood our tendency to follow the herd and take comfort in outsourcing our decision making to others. After all, we have so much to decide in the course of a given day. What suit should I wear? What should I have for breakfast? How should I raise my children? Sometimes it just feels nice to coast and defer to others. As The King appealed to us in his second volume of greatest hits, “50,000,000 Elvis Fans Can't Be Wrong.”

In general, we flock to those with whom we share an opinion and in so doing, surround ourselves with a chorus of “yes people” who reinforce the validity of our own opinions. Given the emotional wrangling that is involved with confronting difficult financial decisions, immersing ourselves in an ideologically homogenous pool is infinitely easier than the alternative. But what is good for short-term peace of mind is not always best for the pocketbook — is following the crowd really a smart way to go?

Some “herding” is natural and even healthy. Church groups offer social and financial support to their congregants. Groups of LGBTQ youth gather to express their shared joys and struggles and learn that “it gets better.” In these and myriad other instances, groups of like-minded people find support and encouragement that propels them toward bigger and better things. Intragroup homogeneity becomes problematic, however, when the need to maintain group purity leads to a lack of “cross-pollination” between groups of different minds. Homogenous groups can lead to what is called “group polarization” or “groupthink” — both potentially dangerous dynamics.

Until the early 1960s, the prevailing theory of group risk-taking behavior was what is called “normalization theory” — the idea that group decisions would reflect an average of the norms of the people that comprised the group. However, a 1961 MIT master's thesis by J.A. Stoner began to question the normalization theory and propose what we now call group polarization — the tendency of a group to engage in behaviors and hold opinions more extreme than the average group member.

The reasons why group polarization occurs are complex, but some suggest that diffusion of responsibility is to blame. Members of the group feel more comfortable putting forth an extreme position because direct responsibility is less likely to accrue to them. Further, given that group members cannot read each others' minds, they also may assume a degree of comfort or agreement with a polarizing viewpoint, since they assume that the core of the group also is in agreement.

Given these and other group dynamics, members become emboldened and take increasingly strident positions, comforted by the size of the group and the potential for anonymity if things go poorly. Consider a fund manager who follows the crowd and takes a popular position, even though he is concerned it may be overbought. Even if the position does poorly, his prospects for future employment are much greater than if he had taken a contrarian stance and been wrong.

So what does herding have to do with your financial decision making? As I have discussed in previous posts, confirmation bias means that you seek out and internalize information that is consistent with what you already believe. Right from the outset, your lens is skewed toward maintaining the status quo rather than toward truly becoming a savvier investor.

Next, we learned that as new information that might challenge your current opinions enters your view, you ward off those attacks by emotionally overriding inconvenient logic. If economic indicators portend bad news about a position, you may ignore it entirely or interpret the data in a selective and favorable light. Finally, you surround yourself with a group of like-minded individuals who nod approvingly at everything you espouse. Perma-bulls and perma-bears don't attend the same cocktail parties. Value and growth investors don't read one another's white papers.

All the while, your participation in this herd behavior is helping to decentralize your opinion and move you toward ever-riskier positions. The brain is a primitive creature set up to maintain ease at the expense of profit and is ill equipped to make complicated financial decisions. So, whether your goal is to live a meaningful life or profit from capital markets, there are times when you'll need to stand alone, resolute in your understanding of truth. Because, while your friends are great to barbecue with, they aren't much help when trying to navigate the road to riches.

Dr. Daniel Crosby is a behavioral finance expert who works with organizations to develop products and messaging to maximize positive investment outcomes. Among his current collaborations is "Personal Benchmark", a system of embedded behavioral finance delivered by Brinker Capital

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