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Why Investors Often Act Like Cattle

From The Globe&Mail…

One psychological flaw that investors fall prey to is what’s known as the herding effect. That’s the tendency for people to mimic the actions of a larger group, whether those actions are rational or irrational.

This was famously demonstrated in a 1958 experiment by social psychologist Solomon Asch. He set up a study in which participants looked at a vertical line in one exhibit and were told to choose the line in the next exhibit that was the same length. The correct answer to this visual test was painfully obvious. But in instances where a number of fake participants were recruited and told to give the same wrong answer out loud, the unknowing participant would follow the herd and choose the incorrect answer more than one-third of the time.

“Often times, people believe that the group is right. They think they must know something that I don’t know,” said Sarah Bull, a principal of the KJ Harrison private client services team. “Herd behaviour has really been a big element of financial history, both how markets have performed and how individual investors invest.”

What that means, she added, is that investors tend to do the wrong thing at the wrong time. “What we’re supposed to do is buy low and sell high, but what investors generally do is the exact opposite,” she said. “There’s a cost to being led astray.”

This cost is easily illustrated by the tech boom of a decade ago. Investors threw money at tech stocks. “Other people were doing it, the headlines were saying it, and so people followed that,” Ms. Bull said.


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