Most long-time investors are accustomed to the phenomenon of herd mentality, or “bandwagon effect.” It causes individuals to make investment decisions based on the idea that “everyone else is doing it.”
This kind of behavior is a component of human nature, although within the context of markets it is generally related to inexperienced retail investors who’re unsure of their very own decision-making and due to this fact resort to panic buying or selling.
For example, the recent price increases in GameStop shares and the cryptocurrency Dogecoin appear to contradict fundamental evaluation and are due to this fact often attributed to herd mentality. The same applies to the dot-com bubble on the turn of the millennium.
When prices of overbought assets suddenly collapse, experts often view this as confirmation of the prevailing belief that the herd is at all times fallacious.
And yet, within the case of GameStop and Dogecoin, Robinhood traders weren’t the one ones driving demand for these assets. Experienced traders and institutional investors were also a part of the stampede. Many of them made money, others got burned.
These market participants – with their sophisticated algorithms and years of investment experience – have actually not succumbed to the 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 into trouble, it’s what you know for sure, but that just isn’t true.”
The irony is that almost all decisions are consistent with the choice of the common investor. That’s just how averages work. When enough people consider their assessment of a situation is best (when it’s actually just average), the herd forms.
The illusion of superiority
Experienced investors are likely to have a distinct type of bias than herd mentality—one which might be just as insidious and might be more chargeable for the GameStop and Dogecoin hype. It’s called illusory superiority bias, and is, briefly, simply an overconfidence in a single’s own decision as being each superior and unique.
Generally, anyone who makes an investment decision based on a well-considered thesis believes that the choice is correct and ideal. Unfortunately, our impression of what is good is commonly clouded by an illusory superiority bias, resulting in a misinterpretation of the facts and a fallacious decision. Sometimes this investment bias even leads us to consciously or unconsciously ignore facts that don’t agree with our thesis, which in turn results in a call that just isn’t ideal.
The illusory superiority bias doesn’t only affect accredited investors in stocks and cryptocurrencies. Venture capital and personal equity firms with long-standing success stories can suddenly find themselves in an unprofitable position resulting from over-reliance on a specific strategy or method of study.
In fact, an illusory superiority bias might be present in almost every aspect of life. It is closely related to what is thought in science as Dunning-Kruger effecta cognitive bias that causes us to overestimate our abilities. This bias affects our perception of every thing from our Driving skills to our relative popularity inside a bunch. It is commonly harmless. But within the context of managing money, it might probably be downright devastating.
Stay alert
So how can we check our investment decisions for signs of bias, be it herd mentality or illusory superiority? How can we make the objectively right decision when there are countless variables to contemplate?
The secret’s to follow first principles and base every decision on internally developed insights and data. The Theranos debacle proves how smart this recommendation is. The so-called blood-testing company, led by Elizabeth Holmes, generated tons of of hundreds of thousands of dollars between 2013 and 2015 – before the corporate’s flagship technology even existed.
In the top, investors and distinguished government officials lost greater than $600 millionThe excitement surrounding Theranos was fueled by otherwise capable investors who followed and promoted a set of core assumptions that turned out to be false.
Here’s easy methods to avoid this final result: Keep our investment thesis in mind when filling our deal funnel, keep our goal criteria in mind when evaluating each opportunity, and strive to acknowledge when the team is following external influences.
This just isn’t at all times easy. It means actively rejecting assumptions about what makes a super investor and even perhaps ignoring common investment strategies. Instead, we must always deal with internally determined outcomes.
Ignore the rumors about funds which have returned 100x invested capital and disrespect benchmarks that do not fit our cohort or our fund’s lifecycle. Set our goals and performance metrics to internally define what success looks like and get to work on achieving those results.
We should try to regulate the forces we will control while monitoring those we cannot. stay disciplined By maintaining independence and objectivity, we will avoid impulsive behavior comparable to panic buying and selling and more successfully discover profitable contrarian positions.
With this approach, we’re prone to make investment decisions, albeit A’s. Ultimately, we’ll be less prone to join the herd – and that is an excellent thing.
If you liked this post, don’t forget to subscribe.
Photo credit: ©Getty Images / baona
