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Why you should avoid the herd mentality in making financial decisions?

Updated: Mar 19

In this information age, the human mind gets more attracted to an event or news which is popular amongst the crowd. Have you wondered how rumours are created? When a large number of people keep on forwarding news on social media without even checking the veracity of it. For instance, the news of the legendary actor Dilip Kumar passing away has been doing the rounds on Wats App very frequently. People mindlessly copy the actions of others and share the news even though it could be a hoax.

Similarly, it is a popular trend these days to send children to coaching classes for medical entrance test (NEET) from the 7-8th standard itself! Many parents imitate other parents without first thinking about the aspirations and strength of their own children.

This human tendency to blindly follow what others are doing is called herd mentality. Herd behaviour arises from the need for social acceptance of belonging to a group or could be to feel secure in a group. If many people are jumping onto some bandwagon, others do not want to be left out or miss the bus. (assuming majority people cannot be wrong). The media also has a big role to play nowadays which kind of induces societal pressure.

Herd mentality can also be best related to financial decision making. The stock market is one of the most common examples associated with herd instinct. Investors are often attracted to hot stocks in which everyone else is investing and which are already inflated in price. Later as prices crash, they find themselves in a sticky situation of whether to book losses or not. Remember the dotcom bubble of 2000. A new dotcom start-up was born every day and stock price of internet related companies were shooting through the roof. No one was thinking of their business and revenue model. Not just stock markets, herd behaviour can be observed in many other financial decisions. Chit funds are another typical example. Lured by easy money, people invest in chit funds as they see many of their friends, neighbours and relatives investing in it. They do not know the modus operandi but still invest in them hoping to get a good return. Eventually, they are fleeced with no hope of even the principal amount recovery. Many chit fund scams have happened in India, including the Sardha scam.

Why herd mentality is dangerous for your finances?

Financial decisions made through herd behaviour are not guided by any solid rationale. Hence, they could probably be not in your best interest. Some decisions can actually have a long term bearing on your finances. For e.g., buying shares on friends tip, buying a property adjacent to the new flat booked by relatives or buying club membership to stay in a group just because close friends have become new club members. Putting money in unfamiliar territory just because the world is doing it can expose you to serious financial risks. You may later realise in the long run that the money is actually lost or suitable investing opportunities have been missed.

Sing a different tune:

Firstly, it is important to realise that you are a unique individual having different aspirations and needs than others. You have your own set of financial goals and risk-taking ability. So, instead of accepting the wisdom of the herd, the most effective way is to devise your own financial plan with your unique goals in mind. Focus on your investment horizon, risk exposure and your personal situation to achieve your financial goals.

Remember, psychology is an important part of investing. As Warran Buffet explains: The greatest enemy of an investor is his own emotions. Here, he is referring to greed and fear. Having a solid financial plan will help you keep your emotions in check and eliminate taking decisions in panic by following the herd. In the end, no matter what every one is doing, the more focussed you are on your long-term plan, the less importance you will give to short term developments and thus cut out the market noise.

This popular saying sums up the post:

If everyone is thinking alike, then somebody isn’t thinking – George Patton.

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