The Biased Investor (Part 4)

Is there safety in numbers?

Photo: W Ribs. Source: Wikipedia

People are social animals. We like to gather together. If we’re isolated, we get lonely. Indeed, solitary confinement—enforced isolation—is one of the most severe kinds of punishments. In animals, prey animals seek cover from one another, and some predators hunt cooperatively in a pack to bring down big game. Also, by staying in a group, individuals can benefit from the information other group members may have about where to find food.

Among humans, crowd psychology has been a field of study for a long time. When we’re in a group, we often act and think as the group does, not necessarily as we would individually. Antisocial activities can be contagious in a mob, like smashing windows and chanting. The French sociologist Gustav LeBon says that when a man joins an organized crowd, he descends several rungs on the ladder of civilization. “Isolated, he may be a cultivated individual; in a crowd, he is a barbarian.”

Crowd in NYC. Photo: Susan Donovan Source: Wikipedia

So it’s no surprise that investors tend to cluster together as well. When a stock or asset class seems unstoppable, investors sometimes pile in, driving prices up to irrational levels. On the other side, falling prices can lead to excessive gloom and devastating crashes. We saw both sides of this behavior during the real-estate bubble and the financial panic that followed. When levered institutions are exposed to speculative assets, this can lead to economic recessions and depressions.

What should investors do? First, be aware that herding is dangerous. When you’re part of a mob, you’re no longer thinking for yourself: you’re substituting the group’s judgement for your own. Second, understand that there’s no “safety in numbers” when it comes to money. Other investors are self-interested actors as well. Finally, do your homework. There’s no substitute for understanding a company’s business model and financial statements. If somethings seems too good to be true, it probably is.

After all, when everyone in a crowd thinks alike, chances are that most of them aren’t thinking at all. And if you can keep your head when everyone else is losing theirs, you may just keep your money, too.

Douglas R. Tengdin, CFA

Chief Investment Officer

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