- Investors want to avoid a herd mentality
- But consulting with others could help avoid costly mistakes
There’s an attraction to moving in a pack – even for central bankers. Last month, economist Dario Perkins joked on X that “independent monetary policy is where everybody waits for the Fed to give them permission to cut rates”. Patrick Saner, head of macro strategy at Swiss Re, replied that rate-setters had “FOGF” – fear of going first. Domestic data will probably override safety in numbers, but there is no denying that it has a powerful appeal.
Investors can feel the same pull, too – and thanks to their sheer numbers, they tend to move as more of a herd than a pack. Sometimes this is understandable: studies find evidence of greater efficiency and safety in groups. But it can also have more negative consequences, especially in a world of online investment hype.
One of the most well-known online forums in this regard is r/WallStreetBets on Reddit, which allows users to share stock tips and investment predictions. Meme stocks are a particular favourite: in 2021, retail investors created a short squeeze in GameStop (US:GME) shares so exciting that it was immortalised in the film “Dumb Money”.
As online hype grew, investors piled into the company's shares, with the number of accounts trading the stock rising from 10,000 to almost 900,000 at the peak of the frenzy. The share price soared, forcing a significant proportion of short sellers to cut their losses and exit the market.
According to Eric Kirzner, professor emeritus of finance at the University of Toronto, “in the short run, the r/WallStreetBets group won, hands down”. Yet over the longer term, the victory looks more hollow: the GameStop share price ultimately plummeted, even if it remains well above pre-craze levels. “It all came to an end when the reality of the company’s real value finally took hold”, Kirzner said. Take a look at the chart below, and the danger of herd mentality feels clear – at least for those who bought at or near the top.
Yet in 2023, a consumer behaviour expert at the University of Sussex Business School showed that investors who make decisions alone made risky choices, too. Dominik Piehlmaier found that traders who made decisions without the input of others were far more likely to bet on falling stock prices or engage in margin trading, offering their portfolio or savings as collateral.
Given what we know about herd mentality, this feels entirely contradictory. But it turns out that herd investors and lone wolves both have something in common: a failure to develop their “meta knowledge”. This is a complicated term for a simple concept – knowledge about our own knowledge (or lack of it). Piehlmaier’s research found that forming an accurate assessment of your skills and understanding is vital when it comes to making good investment decisions.
Crucially, assessing your knowledge is different to increasing it. The study found that although working with financial advisers might boost investors’ objective knowledge, it gave them a limited sense of what they still didn’t understand. As a result, it did little to reduce ‘unreasonably high confidence’.
We could find that forums such as rWallStreetBets play a similar role. Although the forum has a series of rules (including “only comment if you know what you’re talking about… no one wants an ill-informed opinion”), there is still plenty of room for bravado. Kirzner found that at the time of the GameStop squeeze, the website was full of aggressive comments and questionable data. He said that “the early buyers and chatterers made a fortune (for those who got out)”. Latecomers were left holding the bag.
Consulting with others could be key
The good news is that there is a relatively easy way to make better investment decisions. Piehlmaier’s research showed that consulting with family and friends could act as a powerful 'debiasing' tool.
He found that “if friends or family members mention that they do not know the answer to a financial question, it will have a calibrating effect on investors’ confidence in their own financial knowledge”. Emphasising the unknown aspects of an investment can improve our financial decisions. When it comes to investing, it pays to know what you don’t know.
