Markets In Action

Keep Calm and Carry On, Part 2: Watch Out for Herd Behavior

If you’re an investor saving to meet long-term goals like buying a home, a college education or retirement, you should understand the importance of not overreacting when the market plunges.

But that’s not always easy when you’re watching the value of your investment portfolio rapidly decrease. When you see a down market, you may be tempted to join the sellers in an effort to hold on to your gains or minimize potential losses.

You’re not alone in feeling that way, particularly in the era of social media. In a recent article for the Wall Street Journal, UCLA behavioral economist Shlomo Benartzi explores that impulse to follow the crowd.

Benartzi looks at “theory of mind” research conducted by neuroscientists that showed “patterns of brain activity associated with increased betting during bubble markets” for research participants in an experimental market. In other words, as the “investors” in the research experiment saw others bidding up prices, they joined in.
Benartzi suggests “investors who are more attuned to the behavior of others are more prone to herd behavior”- and that response may be governed more by emotion than rational calculation. As he explains:

When [investors] notice someone bidding up a given asset, or panicking and selling after the bubble has popped, they are more likely to join in that activity, even when the price of the asset deviates greatly from its intrinsic value. For these sensitive people, irrational exuberance, and panics, are extremely contagious.

He goes on to note that the effect could be amplified by the connectivity and visibility afforded by social media sites, which may serve to amplify emotional responses to market swings:

Such theories raise an especially important question in the 21st century. We live, after all, in the age of the social network, with hundreds of millions of people interacting on sites such as Facebook and Twitter. While these sites make it far easier for people to learn about one another, they might also make us more sensitive to market swings.

Benartzi suggests a few ways that financial firms could help to protect investors against panics and herd behavior through carefully timed interventions, using text reminders, digital tools and “commitment contracts.” Those may help, but don’t overlook one of the most valuable tools of all-old-fashioned human contact.

A market downturn is a good time to consult with a trusted financial professional, either by using an existing relationship or finding a professional who understands your long-term investing goals – and helps you to plan accordingly. If you are starting to feel uneasy about your portfolio, a financial professional can discuss markets conditions with you  and help you plan  an appropriate course of action.

When it comes to saving and investing, following the herd won’t guarantee success. Instead, keep your long-term goals in mind, know your strategy and when in doubt, consult with someone you trust to guide your investing in the right direction.

 

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If you’re not sure how to proceed when you see a sudden market downturn, review our primer on lessons from the August 2015 market correction, when stock prices dropped precipitously over the course of several days-only to stabilize and recover.

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