Herding: Why do we behave like zebras?

We herd because of the uncertainty of returns on the outcome and the choice of the product

You may have bought a piece of land in a gated community because many of your co-workers did so. You, perhaps, invest in gold schemes for the same reason. Herding comes naturally to us from our ancestors who did so to improve their survival. In this article, we discuss why we herd while taking investment decisions. We also suggest when it is meaningful for you to herd and when it is not.

Crowd comfort

You may have watched it on National Geographic or Discovery channel. When a group of zebras sense a predator, the animals do not run in different direction; they crowd as a group. The ones in the periphery unintentionally protect those at the centre! A hungry predator, therefore, targets the periphery and gets its meal.

We herd like the zebras when it comes to our investment decisions! Why? Consider this. You and your co-workers decide to invest in real estate. You identify a gated community while your co-workers choose another location. Five years hence, your investment gains 50 per cent whereas your co-workers make a 200 per cent gain. How will you feel? Now, consider an alternative scenario. You and your co-workers buy land within the same community. Five years, hence, your investment gains just 15 per cent. How would you feel?

In both cases, you are bound to regret your investment decision. But the regret in the former case would be much higher than in the latter case! Why? Perverse as at it may sound, your regret is higher when you take a contrarian decision and it fails.

On the other hand, your regret is much lower when you know that your co-workers also took a bad decision along with you!

And that is not all. When all your co-workers believe that a particular location is better, you would typically tend to go with the group decision. Call it social conformity if you will. The truth is: The pain of missing out on what seems like a winning investment is more than the possibility of losses on a bad investment. Therefore, we herd. But is herding good for your investment portfolio?

Swarm intelligence

Take the core portfolio, which is created to meet your life goals such as buying a house. This portfolio should contain recurring bank deposits and an index fund. You do not have to herd to create your core portfolio. Why? We herd because of the uncertainty of the outcome — will the returns be positive or negative? We also herd because of the uncertainty relating to the choice itself — is the product better than its peers?

For an index fund, the latter is not an issue. All index funds on the NSE 50 Index, for instance, will provide similar returns. So, you cannot choose a “wrong” index fund. Therefore, the uncertainty comes from returns, which is the inherent characteristic of the product. You should accept this uncertainty if you want to invest in equity. With recurring deposit, the only uncertainty, which is low, is the risk that the bank may fail to pay your deposit at maturity.

Your satellite portfolio is different. This portfolio is created to capture short-term fluctuations in the stock market. So, trend-following and momentum strategies are important. And that means herding! But you should know when to join the herd. Should you buy the stock after it has jumped 20 per cent in just two days or wait for a while?

In general, if you are part of the initial crowd, you will reap handsome gains. But if you join the group much later, you may expose yourself to high risk. Your skill lies in detecting the trend early. You should apply technical analysis to arrive at an informed decision. Otherwise, your investment could face a similar fate like the zebra at the periphery. Beware!

The writer is the founder of Navera Consulting. Send your queries to porfolioideas@thehindu.co.in

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