What is herding bias; all you need to know about it

• Follow

Demonstrations, public riots, religious gatherings, elections, your opinions, career or investment planning – what is the common thread binding them together? They are forms of human-based herd behaviour. A study by the Journal of Consumer Research called Social Defaults: Observed Choices Become Choice Defaults revealed how human beings are inclined to being copycats.

This shouldn’t come as a surprise because, after all, what do we fear the most? Being odd-one-out, isn’t it? Humans are born with the innate desire to be part of the majority. This makes you feel secure and powerful at the same time.

Apparently, one’s investment decisions are no different. We would like to be part of the wolf pack because once the snows fall and the white winds blow, the lone wolf dies but the pack survives. However, financial advisors appear to think otherwise.

Herding bias investments

“Most investors do not know how to analyze markets or schemes and tend to go for anything trending and where they see others investing. This is where herding begins,” Mrin Agarwal, founder at Finsafe India said.

There is a tendency of most of the investors, especially retail, to over-allocate to the flavour of the season. Whenever any sector or a stock starts buzzing, it becomes the most talked about the commodity in the pink papers, TV Channels as well as social and digital media where one is bombarded with the virtues of getting invested in that story. The peer pressure which builds up also creates the Fear of Missing Out (FOMO) factor.

Repercussions

“This tendency does not allow investors to keep focus in markets which is very important to build wealth over the long term. At the same time, this herding bias forces investors to take momentum-based calls that are not useful in the long term. All this leads to de-focus and lack of wealth compounding,” Avinash Gorakshakar, Research Director at Profitmart Securities said.

Meanwhile, according to veteran market analyst Ambareesh Baliga, the herding bias may be a good opportunity for traders to make quick profits since the said sector provides enough volatility and depth for large trades.

“However, as an investor one needs to assess whether it’s a short-term seasonal cycle or a super-cycle. In a seasonal cycle, the window for entry is too short, and only smart & savvy investors are able to capitalize whereas most of the retail investors get stuck at higher levels when the cycle turns down. In a supercycle, which lasts a couple of years, even up to a decade, one gets a much larger window,” Baliga explained.

Many times the retail investor is caught at the wrong end of the stick and the natural tendency is to hold on to a losing trade. Thus, they end up holding the stock till the next upcycle in the sector, sometimes averaging at every fall. And in the next upcycle when the savvy investors are taking fresh positions in their portfolios, these retail investors tend to exit early on achieving their average entry price.

How to exit a rally?

While following the herd can make you enter any rally at its peak but what about the exit? How should one determine that since the exit decision is the most difficult part for any investor to fathom.

“Logically a stock should be exited if there are serious corporate governance issues but when growth stops or shows signs of a slowdown that is the time to exit even if the stock price has not fallen. Most investors wait for a price fall and get trapped,” Gorakshakar asserted.

Power of compounding 

To compound wealth in equity markets, investors need to take at least a 5-year view and not a 3-12 month view on stocks and businesses. One needs to think big as an entrepreneur.

“Today’s Robin hood investors haven’t seen a bear market like 2004 or 2008. They want instant gratification. The best way to compound wealth is to use a bear market to invest in quality stocks which eventually generate a very strong alpha based on their business model, cash flows, and operating returns,” Gorakshakar said.

Avoid falling prey to herding bias

Several studies indicate that one gets prone to herd biases when we lack enough information about any subject. If you have a well-planned and researched strategy, you’ll always remain confident about it.

“Remember to invest as per your financial goals and investment horizon. Assess the risk associated with an investment carefully before jumping into a trending product,” Mrin advised.

According to Baliga, the key to good investment is sector allocation and sticking to it, “Typically one should not have more than 4% to 5% in any single stock, especially a mid or a small-cap the exposure should be slightly lower. There should also be a cap on sector exposure – typically heavyweight sectors around 10%-15% each and others around 6% to 10% based on the outlook. However, when a specific sector is in a convincing uptrend, the exposure could be increased but surely not beyond 20%.”

It is not necessary to have exposure across all sectors – whereas the above formula will ensure exposure across 8 to 12 sectors spread among 25 to 30 stocks, thereby decently de-risked.

But above all, discipline is the most important value which if not followed can cause your portfolio to go awry.