Emotion drives many decisions that we make in life and investing is no exception … but it should be. Colonial First State have written the following, excellent article on the traps of emotional investing.
Herd behaviour is driven by emotional rather than rational behaviour. Often little attention is paid to investment fundamentals as investors focus on what other people are reacting to in the market.
All investors are prone to behaviours and emotions that can lead to poor investment decisions. One of the most common pitfalls is known as ‘herd behaviour’. This describes large numbers of individuals acting in the same way at the same time, typically by buying into rising markets and selling out of falling markets. This behaviour can cause markets to dramatically rise and fall in value – known as ‘bubbles’.
Bubbles can only be identified with hindsight, after a rapid and marked drop in value has occurred. These sudden drops are sometimes referred to as ‘crashes’ or ‘bubble bursts’. Because bubbles are only identified in retrospect, many investors often get caught out by the sudden and rapid decline in the value of their investment.
Herd behaviour is driven by emotional rather than rational behaviour. These emotions are typically optimism and greed when markets are rising, and fear and panic when markets are falling. Little attention is paid to the investment fundamentals, which means herd behaviour rarely leads to successful investment outcomes.
There are two main drivers of herd behaviour when it comes to investing. Firstly, people don’t want to miss out on making a profit. Secondly, we assume that when a large number of people are buying into the same investment, they can’t all be wrong. This means that there is often little understanding of the underlying investment, and more attention is focused on what other people are doing. Consequently, it is often the less experienced investor who gets caught up in herd behaviour.
It’s October 1999 and Ken has been keeping an eye on the sharemarket. Everyone is talking about the exciting future of technology companies and he has noticed most of them have doubled in value during the past 12 months. He doesn’t know much about investing or technology companies, but assumes all the other investors know something that he doesn’t. Without really understanding why the stocks are rising, he invests $10,000 in a technology-based index fund, reassured that many other investors are doing the same. Four months later he is delighted that the value of his investment has risen more than 50%. All those people were right after all.
Then, in February 2000, his investment starts losing value and Ken can’t see any reason behind the fall. All of a sudden everyone is rushing to sell their technology stocks and no one is buying any; the exact opposite of just a few weeks earlier. The drop in value is so abrupt that by the time Ken reacts and sells his holdings he has lost most of his original investment.
Like many others who had jumped on the ‘dot.com’ bandwagon, Ken did not do his research and invested without fully understanding the sector or risks. He thought to himself “this time it’s different”. Looking back he acknowledges that the signs of a bubble were there for all to see.
One way to avoid such a pitfall is to invest in a well-diversified professionally-managed investment fund. Managed funds will typically have a disciplined investment process which is designed to meet long-term investment goals, rather than be concerned with following the latest trend. Most managed funds will also have a team of analysts who will research and analyse companies based on proven economic measures, rather than relying on the emotions of others.
As mentioned in the article understanding your investments is one way to avoid ‘herd behaviour’. Please contact your Byfields Wealth Financial Adviser if you have any questions.
This document has been prepared by Colonial First State Investments Limited ABN 98 002 348 352, AFS Licence 232468 (Colonial First State) based on its understanding of current regulatory requirements and laws as at 25 June 2014. While all care has been taken in the preparation of this document (using sources believed to be reliable and accurate), to the maximum extent permitted by law, no person including Colonial First State or any member of the Commonwealth Bank group of companies, accepts responsibility for any loss suffered by any person arising from reliance on this information.
General Advice Warning: The information on this site including any information contained in any of the blog posts is of a general nature only. It does not take your specific needs or circumstances into consideration. You should look at your own personal situation and requirements before making any financial decisions.