Following the Herd: Why We're Wired to Be Bad Investors
Perhaps no book changed the way I think about the world than Daniel Quinn's Ishmael. Though I won't get into the specifics of the book, the most important takeaway from an investing perspective is to consider the long view of human evolution. When we take that view, it's easy to see why -- for many of us -- successful investing is a difficult task.
To get an idea of what I mean, consider the continuum of time that humans have been on the earth. For quite a while, we were hunter-gatherers. That gradually ended about 10,000 years ago when humans began farming -- which seems like a pretty long time. But as Tom Shenk, in an article for the Virginia Education Association, pointed out, this isn't the case.
Source: Author illustration of Shenk's assertion.
As Shenk says:
Let's pretend that all of human history has been condensed into one year, with January 1 as the day when early man first came on the scene, and December 31 as the present. ... If all of human history were condensed into one year, we would've learned to farm... yesterday, December 30! That's right! We've spent 364 "days" as hunter-gatherers and only 1 "day" as farmers. That means that for the vast majority of our history, our brains had wired themselves to be most successful in a hunter-gatherer environment.
Why following the herd makes sense
Take an extended trip into the wild, and you'll see that highly social animals -- of which humans are one -- are consistently reliant upon their peers for food and protection. For monkeys, that protection is in the form of a troop; for humans, it was in the form of tribes; and -- for the purposes of this article -- for buffalo, it was in the form of a herd.
Sticking close to one's herd had several advantages. Raising the young was a communal experience, and the task of traveling and searching for food was split evenly. Just as important, when a herd of African buffalo, for example, was attacked by lions or leopards, sticking close to the herd was crucial for survival. If one strayed from the herd, it became an easy target for predators.
The same general principal can be applied to the vast majority of social creatures: In times of distress, sticking to the herd provided safety.
What this means for investors
Unfortunately for investors, this ingrained behavior -- which we clearly haven't had time to evolve out of -- can significantly reduce our ability to achieve financial freedom through investing in the stock market.
As our own Morgan Housel explained:
Investors consistently ... get excited when stocks rise and rush out to buy more, and sell with abandon when markets head down. ... We've written about the hazards of buying high and selling low ad nauseum. But it's the most common mistake investors fall for.
And that makes perfect sense. When the market goes down, and we lose money, it's an understandable knee-jerk reaction to panic, to feel stress. That stress causes us to seek safety, and that safety usually involves following the masses toward selling.
How to cope
Don't feel ashamed or guilty if this describes an investing decision you've made in the past. More than making you a bad investor, this tendency means that you're only human. As best I can tell, there are two tried and true methods to help cope with our tendency to follow the herd in times of stress.
The first is to follow a strict buying plan in low-fee, broader-market ETFs. By investing a set amount in selected funds or ETFs every month -- and only periodically checking your balance -- you can enjoy the financial benefits that investing in the market provides without the psychological discomfort.
For those desiring a more hands-on approach dealing with individual stocks, I've found no method to be more reliable than keeping an investing journal. By writing down exactly why you are buying and selling stocks, you are forcing yourself to slow down that knee-jerk reaction, and allow a slower, more balanced thought pattern take hold.
Not only could keeping this journal improve your investing, but looking back at it can help you evaluate what strategies have, and haven't, worked in your investing approach.
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