Most long-time investors are familiar with the phenomenon of herd bias, or “the bandwagon effect.” This leads individuals to make investment decisions based on the belief that “everybody does it”.
This type of behavior is part of human nature, although in the context of the markets it is usually associated with novice retail investors who are not confident in their own decision-making and therefore resort to panic buying or selling.
For example, recent spikes in GameStop stock price and the cryptocurrency dogecoin, among others, seem at odds with fundamental analysis and are therefore commonly attributed to herd mentality. The same can be said of the dotcom bubble at the turn of the millennium.
When overbought asset prices suddenly crash, experts often see it as confirmation of the prevailing wisdom that the herd is always wrong.
And yet, in the cases of GameStop and dogecoin, Robinhood merchants weren’t the only ones driving demand for these assets. Veteran traders and institutional investors were part of the stampede. Many of them earned money and some were burned.
These market players – with their sophisticated algorithms and years of investment experience – certainly did not succumb to a herd mentality. So why did they join the herd?
As the old saying goes, “It’s not what you don’t know that gets you in trouble, it’s what you know for sure that just isn’t so..”
The irony is that most decisions are the average investor’s decision. That’s how averages work. If enough people think their assessment of a situation is superior (when in reality it is just average), the herd forms.
The illusion of superiority
Experienced investors are subject to a different type of bias than the herd mentality – a type that can be just as insidious and is probably more to blame for the GameStop and dogecoin frenzies. This is called illusory superiority bias, and in short, it’s simply an overconfidence that our decision is both superior and unique.
Generally, anyone who makes an investment decision backed by a thoughtful thesis thinks the decision is correct and ideal. Unfortunately, our impression of what is ideal is often clouded by an illusory superiority bias, leading to incorrect interpretation of facts and incorrect decision in turn. Sometimes this investment bias even leads us to consciously or unconsciously ignore facts that don’t fit with our thesis, again resulting in a less than ideal decision.
The illusory superiority bias does not only affect accredited stock and cryptocurrency investors. Venture capital and private equity firms with a long track record of success can suddenly find themselves in unprofitable positions due to overconfidence in a particular strategy or method of analysis.
In fact, delusional superiority bias can be found in almost every aspect of life. This is closely related to what is known in academia as the Dunning–Kruger effect, a cognitive bias that leads us to overestimate our abilities. This bias paints our perception of everything, of our driving abilities to our parent popularity within a group. It is often harmless. But in the context of money management, it can be downright devastating.
Stay on guard
So how do we check our investment decisions for signs of bias, be it herd mentality or delusional superiority? How do you make the objectively correct decision when there are countless variables to consider?
The key is to stick to first principles thinking, basing every decision on findings and data developed internally. The Theranos debacle proves the wisdom of this advice. The so-called blood testing company run by Elizabeth Holmes grossed hundreds of millions of dollars between 2013 and 2015 – before the company’s flagship technology even existed.
Ultimately, prominent investors and government leaders lost over $600 million. The turmoil around Theranos was perpetuated by otherwise capable investors who followed and propagated a set of basic assumptions that turned out to be wrong.
Here’s how to avoid this outcome: stay mindful of our investment thesis as you complete our deal funnel, keep our target criteria in mind when reviewing each opportunity, and strive to detect when the team is following the lead. example of outside influence.
Its not always easy. This means actively rejecting assumptions about what makes an ideal investor and perhaps even ignoring popular investment strategies. Instead, we should focus on internally specified results.
Ignore rumors of funds that return 100x invested capital and block benchmarks that don’t match our cohort or fund lifecycle. Set our goals and KPIs to internally define what success looks like and set out to achieve those results.
We should aim to design the forces we can control while observing the ones we cannot. By stay disciplined When it comes to independence and objectivity, we can avoid impulsive behaviors such as panic buying and selling and be more successful in identifying profitable contrarian positions.
By taking this approach, we are likely to less investment decisions, although more intelligent those. Ultimately, we’ll be less likely to join the herd – and that’s a good thing.
If you liked this article, don’t forget to subscribe to the Enterprising investor.
All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
Image credit: ©Getty Images / baona
Professional Learning for CFA Institute Members
CFA Institute members are empowered to self-determine and report professional learning (PL) credits earned, including content on Enterprising investor. Members can easily register credits using their HGV tracker online.