In the world of personal finance, many of us are just like lemmings jumping off cliffs. (Yep, lemmings really do jump off cliffs!) It’s entirely possible that you can relate because at some time in your past you remember following your peers off a “cliff”. That is, you were subconsciously persuaded by your peers to act in a less than rational manner! Don’t believe me? Tag along as we discuss several examples of financial herding, and how to avoid this trap!
Herding Mentality Gone Wild
Herding describes when a group of people adopts similar behaviors to those around us. Let me give you an illustration to prove the point.
There was a study with the University of Leeds about how people behave in large groups. Professor Jens Krause and Ph.D. student John Dyer noticed in crowds of 200 people or more, it only takes 10 people to influence the direction in which the group travels.
Let’s say that 200 people are confidently walking south. If only 10 people change direction, the hundred and 90 people behind them will follow. Talk about herding mentality!
I’ll bet that you have experienced this phenomenon. You’ve been in a crowd where people are leaving the venue, and when they start heading in one direction and you’ll start following because presumably, they are going in the right direction. Although you might discover after a few minutes of the herding mentality that you are going in the wrong direction!
The History of Financial Herding
History teaches us that herding is part of our financial DNA, too.
In the 1600s there was a Tulip bulb craze. Tulips were hard to transport, slow-growing, and delicate. The Dutch eventually figured out that if you bought the seeds, and let them grow into a bulb (this takes several years), you could sell the bulb, which is much easier to transport and trade.
Everyone wanted Tulips because they were a sign of wealth. So, if you planted them you also had a tangible sign of wealth. The cost of a single tulip bulb skyrocketed due to the herds of humans that would buy something with very little intrinsic value.
How crazy did this craze get? One bulb was worth the annual income for a skilled crafts worker!
Herding Mentality and Finances
There are more modern-day examples of the financial herding mentality, too. This includes the beanie baby craze, cryptocurrency, or the many other modern-day stock market bubbles.
However, when making financial decisions it can be disastrous to follow the herd. When it comes time for you to creating your backwards budget, investing, and long term financial goals, it’s definitely time to choose your own path and deal with due diligence!
Following the recent trends often proves unhelpful. If you don’t believe me, go back to the list of the largest 50 companies in existence 50 years ago. Then, tell me how many of them are still there today. Not many, right?
Market crashes are also very real examples of the financial herding mindset.
Consider the housing bust of 2008-2009 when people were getting home loans from subprime mortgages. They probably wouldn’t have qualified for other kinds of home loans, so that meant they couldn’t afford to make payments.
The banks were greedy, and there were no laws in place or being enforced about who they could lend money. They would loan money to anyone.
There were people who were buying houses and becoming overextended and they couldn’t pay their mortgage. Too many people thought they could become millionaires with real estate. (Honestly, if you are looking for where to get started in Real Estate, you should probably start here).
Some were buying houses without incomes. When the market went downhill, the panic started, and everyone wanted to sell (or they were getting foreclosed).
Avoiding the Financial Herd Mentality
One step in avoiding the herd mentality is not to worry about the future. Don’t worry about the trade wars, or who will be the president. And, don’t time the market!
Start looking into the future, say 10-15 years (or longer). If you are experiencing your new attending physician paychecks your investment horizon is probably far in the future. You are looking for things that will hold out for the long term, not something that you plan to sell tomorrow.
First, paint your big financial picture using The Three Kinder Questions. Save and invest your money (and/or pay down your student loans) first before you see it in your bank account. And then utilize intentional spending to avoid buyers remorse.
When you invest, keep it simple. Pump the money in. Ignore the market. And you’ll find success.
This looks very different than most who check their investments daily and love to watch them grow (funny how they never mention them going down). I can’t help but wonder if this is the money they are counting on in their path to reach financial independence.
The problem here is that these sort of antics often rub off on others. Most of us have witnessed the herd mentality when we see other physicians think that if something is good enough for one colleague, it must be good enough for them. People need to do their own due diligence, and not let friends and family influence them.
That’s a tough call because the people we spend the most time with tend to influence our decisions.
Aren’t Index Funds A Herd Mentality, Too?
If you have been reading this site for any time, it may have crossed your mind in this discussion whether index funds are an example of herd mentality, too.
Many of us in this space regularly endorse passive index fund investing. Myself included. If you follow me, are you like the lemming or wildebeest jumping off the cliff? Are index funds another bubble that is waiting to burst?
Nope. Not really.
The overall market size and trading of what goes into the passive versus active strategy are still extremely small compared to the overall vast market.
However, index funds are becoming more popular. This is why some companies are starting to offer zero percent expense ratio index funds. They do this because they can make money in other ways once they attract these new customers.
If investing in index funds is an example of a financial herding mentality, at the moment it’s a very small herd. However, it is gaining momentum. And, unlike lemmings jumping off a cliff, I think that’s a good thing.
That is one herd that I hope will continue to grow.
Do you have a herding story for us? Leave your comments below.