Herd-Behaviour

Investment decisions can be heavily influenced, not only by emotions but also by the context in which they are made, such as your own past experiences or the advice of friends and other traders.

When something seems obvious and all the websites, blogs and forums say that a specific event will happen, most people are led to believe that it will. This is the so-called herd behaviour, which describes a set of actions and decisions taken by many individuals without any prior coordination between them.

I will give you an example. After making your analysis, you decide to sell crude oil. However, after making this decision, you switch on the TV and see an oil expert on a financial channel, discussing how oil supplies are about to shrink because OPEC is considering reducing production, or oil companies are exploring less, and so on.

Slowly, bit by bit, you start feeling less confident in your decision to sell crude oil. You decide to close your trade and lose $200. But you had a stop-loss of $500, and the price on that day never hit it.

The next day, crude oil starts a bearish phase, just as you had hypothesised, and instead of a profit, you end up with a loss. And what happens in these cases? Not only do you lose money, but you also lose confidence in yourself, which is a lot worse.

Herd behaviour explains irrational phases in the market, such as speculative bubbles or investors selling off in a panic, indiscriminately getting rid of financial assets they consider (usually incorrectly) to be overly risky. For instance, this occurred between 2008 and 2009, when, after the Lehman Brothers collapse, there was a seemingly endless wave of bearish alarm with significant repercussions.

Nevertheless, those who decided to leave the flock and start buying shares in 2009 can be proud of their choices. Since then, the US stock market has grown remarkably, touching record highs several times.

Why are we led to follow the ideas of others? An experiment by Solomon E. Asch, reported in his book Social Psychology (1952), showed how human beings tend to place more weight on other people’s judgments than on their own.

Asch divided the participants of his experiment into small groups. In each group, all the members except one were his collaborators, who had been instructed in advance; the one real participant did not know this. Asch showed the group a reference line and three other lines, and asked each member, one by one, which of the three matched the reference line in length.

His collaborators deliberately gave the wrong answer, and in about one third of the cases (37% in the results he later published), the real participants gave the same wrong answer as the group, even though the correct one was obvious. This experiment explains why, although aware of the risk of a potential market collapse (e.g., in the case of a speculative bubble), investors often choose to follow the speculation rather than leave the “flock” and save their investment.

Herd behaviour is, therefore, one of the many mental traps widely described in behavioural finance as a form of conditioning that leads us to act as a mass, often without thinking about our specific needs and personal characteristics.

I am not telling you to ignore the ideas or the opinions of others, not to read the news, or not to watch a financial channel on TV. What is important is that you always do your own evaluations. Make your own choices (you should spend an hour or more every day making them).

Make your analysis, draw your conclusions, and then follow them. Changing your mind continuously is useless; it will not get you anywhere, and even worse, you run the risk of getting burned, just like you saw in the example above.

I know that the concepts I am explaining can be viewed as less important or easily forgotten. Therefore, it is essential that you read and re-read this course so that these steps become more and more systematic, almost automatic.

It is fine to follow the teachings of others, especially from traders who have more experience than you. However, you have to build your own rules, a simple and precise plan, and most of all, a way of thinking things through yourself, without the interference of friends or experts on TV.

So, what do you have to do? You have to look at each trade objectively. Do not fall in love with an idea or opinion. Always look at your trades with objective respect. Learn to recognise the differences between what you see, what you feel, and what you think.

Stop placing too much importance on the opinions of other traders and experts. As a famous old adage says: “trade what you see, not what you think.” Spending too much time in front of a screen, or becoming overconfident, as I explained in the previous post, will lead you to trade what you think, trade your market view, and trade with your emotions. The more you remain detached from all this, the more you will be able to remain rational in your decision-making.