BACK TO THE BOUTIQUE INVESTOR BLOG The Urge to Herd: A Hidden Source of Client and Advisor Angst A recent advisor survey from CFA Institute identified herding as the single most destructive behavioral bias affecting individual investors (see chart).1 As its name implies, the herding instinct describes the powerful drive we all have to blindly follow what others around us are doing. A decision to follow the crowd taps into deeply rooted relational desires in the human brain to appear wise to others and to avoid looking foolish. Herding is one of several behavioral biases that are credited for the low returns investors have earned versus the overall market throughout the last several decades.2 Source: CFAinstitute.org Driven by Envy, Not Greed Herding among individual investors is often misunderstood as being driven by a desire to gain wealth. However, a study of investor behavior found that herding happens not because investors think there is a good opportunity at hand, but because they fear missing out on gains that others around them are achieving.3 So who do investors look at when comparing their results? “About one-third of households evaluate how well they’re doing by using their neighbors as the benchmark, with work colleagues and family members being the next most common metrics.”4 The truth is, the real driver of herding is not greed, but envy. It’s all about keeping up with the Joneses. Timing: Why Herding Doesn’t Pay According to Jean-Paul Rodrigue’s four stages of a stock bubble, the public’s herding instinct peaks during the Mania Phase, when both the valuation (cost) of a security and its risk are rising. Herding kicks in again during the Blow off Phase as investors sell into a falling market. This means that, by the time your clients catch wind of a “new” investment idea, the big gains are usually gone and the risk is high. Guiding Your Clients The herding instinct has a long history of ruining fortunes. From the tulip bulb mania of the 1630s to the dotcom bubble of 2001, investors have a hard time resisting the impulse to follow the crowd. Clients who are aware of the lure of herding will be better able to resist it. Here are a few ways to prepare them: 1. Discuss how media-generated hype can produce a fear-of-missing-out (“FOMO”) effect that could, if left unchecked, negatively impact their investment plan. Cite examples from recent bubbles. Explain that though rational investing may feel like a harder path, it’s more likely to pay off in the long run. 2. Arm them for their next cocktail party discussion by talking through overhyped areas of the market, showing them potential signs of overvaluation. A good example of herding happened in 2017 just after Thanksgiving: “The largest bitcoin exchange in the U.S. – Coinbase – added about 100,000 accounts around the 2017 Thanksgiving holiday . . . much of it due to social interaction between family members at the Thanksgiving table,” says Florian Ederer, assistant professor of economics at the Yale School of Management. “When we see our peers making a profit without us, whether on bitcoin or something else, we jump on the bandwagon, even as it trundles straight for a cliff.”5 3. Let clients know that the ability to resist the herding instinct has been a hallmark of some of history’s most successful investors, including Sir John Templeton and Warren Buffett. 4. Redirect clients away from a focus on their neighbors’ success to a personal, goals-based approach to their own planning. Competing with their neighbors is a poor substitute for a customized financial plan that will help them achieve their life goals. The instinct to join the crowd is deeply ingrained in the human psyche, and that’s not about to change. It is possible that the herding instinct, which we now know is driven by a fear of missing out, is at the root of most advisor-client problems. Clients who compare themselves with their neighbors may be less likely to follow sound financial advice and more likely to become disgruntled about even the most solidly crafted plan. To the extent you are able to help them see the trap of envy and redirect them to a solution centered on their own personal goals, you’ll be building a foundation for a better relationship for years to come. 1 “The Herding Mentality: Behavioral Finance and Investor Biases,” Shreenivas Kunte, Enterprising Investor, CFA Institute, August 6, 2015, https://blogs.cfainstitute.org/investor/2015/08/06/the-herding-mentality-behavioral-finance-and-investor-biases/ 2“Quantitative Analysis of Investor Behavior,” Dalbar, December 31, 2018, https://www.dalbar.com/ProductsAndServices/QAIB 3“Five Ways to Avoid Herd Investing,” Jeffrey Strain, TheStreet, December 5, 2007, https://www.thestreet.com/personal-finance/savings/five-ways-to-avoid-herd-investing-10387968 4Status Anxiety Or: How Our Neighbors Make Us Worse Investors,” Joachim Klement, Enterprising Investor, CFA Institute, August 14, 2019, https://blogs.cfainstitute.org/investor/2019/08/14/status-anxiety-or-how-our-neighbors-make-us-worse-investors/ 5“Investing Responsibly Benefits Everyone,” Coryanne Hicks, U.S. News & World Report, April 30, 2018, https://money.usnews.com/investing/investing-101/articles/2018-04-30/the-right-kind-of-herding-behavior-lifts-all-portfolios