Herd behaviour and recency bias

In simple terms

People are social. When everyone around us is doing something, it feels safe to join in, and when everyone is fleeing, it feels dangerous to stay. In markets, this herd behaviour, along with recency bias, the habit of expecting recent trends to continue, leads investors to buy after big rises and sell after big falls: the opposite of buying low and selling high.

Herding and fear of missing out

Herding has some logic: if many people are buying, perhaps they know something. But often they are simply following each other. Each new buyer pushes prices up, which attracts more buyers, until the price depends more on the crowd than on the business.

Fear of missing out (FOMO) is the feeling that drives late buyers: friends, colleagues and social media are full of gains, and staying out feels foolish. It is strongest exactly when prices have already risen most.

In panics, the herd runs the other way: falling prices prompt selling, which pushes prices lower, which prompts more selling.

Recency bias

Recency bias means giving too much weight to what has happened lately. After several good years, investors tend to expect more good years; after a crash, they expect more crashes. Recent returns feel like the "normal" ones.

But strong past returns often mean higher prices and lower future returns, not the reverse. The bull and bear markets lesson shows how markets move in cycles rather than straight lines.

Buying after the run

When many investors behave like the late investor, the average investor's return can be well below the fund's return. The gap between them is sometimes called the behaviour gap, and it shows up when comparing an investor's XIRR with the fund's own return.

Bubbles and panics

Herding and recency bias, combined with easy credit and a compelling story, can create a bubble: prices rise far beyond what the underlying businesses or assets can justify, until buyers run out and prices collapse. History has many examples, discussed in the investment mistakes lesson.

Signs often seen in bubbles:

• Prices rising mainly because they have been rising.
• New investors entering in large numbers, often with borrowed money.
• Claims that old ways of valuing things no longer apply.
• Scepticism treated as foolish.

None of these signs can time the top, but they can warn you not to raise your risk because everyone else is.

Resisting the crowd

• Follow a written plan, with allocation ranges and rebalancing rules, as the investment policy statement lesson explains. Rebalancing automatically trims what has risen and adds to what has fallen.
• Invest regularly and automatically, so you are not choosing when to get in.
• Ask what is already in the price. Good news everyone knows is usually reflected in prices.
• Be wary when the reason to buy is that others are buying.

Why it matters

Herding and recency bias explain why so many investors buy high and sell low, and why their returns trail the very funds they own. Recognising the pull of the crowd is the first step to not following it.

Limitations

Not all trends are bubbles, and momentum in prices can persist for long periods. Going against the crowd is not automatically right either. The aim is not to be contrarian for its own sake but to make decisions from your plan rather than from the crowd's mood.

Common mistakes

• Choosing funds by last year's return.
• Raising risk in a boom because everyone else is.
• Selling in a panic because everyone else is.
• Treating popularity as evidence.

Try it yourself

1. Find a fund or sector that was popular after a strong run some years ago, and look at its returns in the years that followed.
2. Compare your own XIRR in a fund with the fund's return over the same period. If yours is lower, look at when you invested.
3. Write down what you would do if your favourite investment doubled in a year, before it happens.