Tuesday, December 1, 2009

Become a successful investor by avoiding 'herd mentality'

There are many ways and means to become a successful investor. One way is to be aware that certain behavioural flaws exist in human beings - like 'herd mentality' - and avoid them.

It is logical to expect that a group of people can become successful investors by taking better investment decisions. Why? As more information gets shared and different view points and experiences get discussed and assimilated, the process of deciding which stocks are good 'buys' and which stocks are 'duds' become easier.

The large number of investment groups on the Internet, some with several thousand members, point to the popularity of such joint investment decision making. So the members of these investment groups should be rolling in money, right?

The reality is otherwise. Some times group decision making can be flawed, specially if enough research, or an opposing view, is not taken into consideration. A few individuals, regarded as knowledgeable by group members, can mislead the group inadvertently.

A good example is the mad rush to buy infrastructure and real estate stocks in the later stages of the bull market in 2007. Many investors entered these stocks when they had risen way past the prices that discounted huge growth expectations well into the future.

'Land banks' was added to the investment vocabulary, just as 'eyeballs' were added during the dot.com boom at the turn of the century and 'replacement costs' were touted for pushing overpriced stocks during the Harshad Mehta scam in the early 1990s.

Even seasoned fund managers are not immune to such 'herd mentality' - and the price is paid by legions of small investors. The plethora of 'infrastructure funds' launched in 2006-07 are mostly languishing while the BSE Sensex has gained more than 100% in the past 9 months.

A quick look at the top holdings of popular diversified equity funds is equally revealing about the 'herd mentality' that leads to poor investment performance:-

  1. HDFC Top 200 - SBI, ICICI Bank, Infosys, ONGC, L and T
  2. DSPBR Top 100 - TCS, L and T, SBI, Reliance, ITC
  3. Sundaram Select Focus - SBI, ICICI Bank, Reliance, Sterlite, Shree Renuka Sugars
  4. HSBC Equity - SBI, Infosys, Reliance, ITC, BHEL.

Investors buying into these four funds may think that risk has been mitigated through diversification. But they have actually invested in the same stocks (with one or two exceptions).

Herd mentality is further compounded by bad timing. Money is literally poured into fund houses when the BSE Sensex is at or near a top, and pulled out by cart loads when the index is languishing near the bottom.

One of the tricks to being a successful investor is to avoid the herd mentality. Particularly when the herd is talking about esoteric investment ideas like alternative energy and water management. Stick to the knitting - invest in what you know and understand.

Related Posts

About Confirmation Bias in the Stock Market
Some practical examples of Behavioural Finance


Jasi said...

Sir :) thanks for the your WOW (words of wisdom)!
That was indeed WOW ... I think that way you have the WOW factor ;)
Ok, so coming back, I believe what you ve said is to be taken with a pinch of salt. I personally feel its got a lot to do with risk profile of a person. Usually, if you are following the herd you are making a safe choice which, I agree, might not give you stellar returns but, may give steady and safe returns.
Being contrarian could mean walking against the winds, something everyone might not like.
Im just thinking loud here :)
Your thoughts sir?

Madhu said...

I 100% endorse your views. Unfortunately most of the retail investors are last to enter the market and the fall is so steep that they will never think of the market till the next peak. They start blaming everyone except themselves.
During the bear phase retail investors blame Jhunjhunwalas, bharat shahs and others for their debacle. But they dont realise that these so called bulls are not supposed to give free advice. If they give one then it wud be with some ulterior motive.

Unknown said...

Group decisions can be flawed in a number of ways:

1) Trusting a member and taking everything he/she says at face value. What typically happens is either no analysis or very less analysis. While a 'bad factor' may be staring at us in the face, we can choose to give less importance to it and gloss over the feel good factors listed.

2) We all know what "too many cooks" can do. But, what typically happens is - in a crowd, we tend to accept more people mentioning the stock as a "strength" rather than weakness.

3) As a variation of the above, we can spoil our own profit booking plans due to the "confirmation bias".

Typically it goes like when stocks run up too much, too soon -

"May be I should book part profits here. After all it is 3X my buy price. But, wait a minute! This X guy is smart. He is buying at CMP. May be there's an explosive move up ahead or some news is coming out. Let me hold"

4) Wide variety of people in forums "crowd out". There are too many recommendations, too many stocks and typically, they all "go up". So, we often step outside our C-o-C and chase stocks.

5) What we typically forget is that each individual is unique. Even if we have an overlapping portfolio, my goals, buy and sell levels, holding power, purchasing power, risk taking ability etc., need not match with you.

In a group though, we take comfort in the "herd". If many people follow a certain pattern, we try to follow the same without even thinking whether their intentions are the same as ours. They may be swing traders and we may be long term investors.

The fact is that to figure out people, it takes quite a while. What we "think" is since we may not have the time and means to do that, we should not miss 'plenty of opportunities' in the middle and tend to follow blindly.

After all, everybody is doing it. So, in case we go down, we think that we can picture people jumping out of the boat. But, we do not realize that we are always blind folded by emotions and those who had jumped out have already taken away all lifesavers.

Subhankar said...

@Jasi: Yes, there is definitely some safety in herds. Imagine a herd of wildebeest jumping in to cross a crocodile infested-river. The flailing hooves of the large herd tend to confuse the crocs. While most make it across, a few of the wretched animals become food. I'd rather be a croc in the river.

@Madhu: At every market peak, a new set of naive investors jump in and lose money. But they have an important role to play. They help a few smart investors to become rich!

@Eswar: You have pretty much covered the investment group scene. A couple of points: some groups are closely moderated and that is detrimental to a free and open exchange of information and opinions; a few thought-leaders manipulate opinion towards stocks that they have already acquired at lower levels. Investors should be aware of it.

sumi said...

So true n yet so difficult to resist. It really requires strong emotional discipline.