Most of us are familiar with the idea of “herd mentality” - the tendency to follow other people’s choices because we believe the wisdom of the group may trump individual judgement.
Following other people’s financial advice, however, can lead to financial disaster. We explain the herding effect, the damage it can cause, and how you can avoid succumbing to it when making money decisions.
Tip: Learn how to grow your own wealth through interest-bearing investments.
What is the herding effect?
When people feel uncertain or are under pressure, they may follow the actions of a group rather than act on their own beliefs or preferences, says psychologist Quinton Williams.
“In biology, when the herd crowds together, those in the centre are safest while those on the periphery are most vulnerable,” he explains.
“In social psychology, this behaviour is formally categorised as ‘groupthink’ – a way in which members of society attempt to cope with anxiety by minimising uncertainty.”
Thulisile Nkomo, a private wealth manager at NFB Private Wealth Management, says people who constantly seek validation from others, or experience self-doubt, are more likely to follow the herd. However, they may lack accountability as they take refuge in the anonymity of the group.
How does the herding effect harm our finances?
Nkomo says following the herd can cause you to waste money through unnecessary spending, especially when attempting to gain social acceptance. “It can lead you into serious debt,” she cautions.
Williams says that when people feel anxious or threatened, they are often driven by fear or greed. “They’re unable to think rationally, which leads to behaviours such as panic buying or investing in a Ponzi scheme.”
Warren Ingram, director and co-founder of Galileo Capital, says emotions may be helpful in life-or-death situations, but unhelpful when we need to make rational, multi-year decisions in the markets.
“Investors who stay invested through market cycles make more money than those driven by greed and fear, who buy and sell constantly,” he notes.
People may rush towards get-rich-quick schemes if they have limited knowledge of investing, and believe others hold the key to wealth, explains Philani Shandu, a behavioural economist and senior manager at Standard Bank.
“It’s difficult to resist the temptation of a pyramid scheme, especially where others appear to be making good money.
“Some people may be so swept away that they finance their participation with a loan – but they invariably lose most or all of the money,” he says.
Taking back your power
Ingram says the best way to inoculate yourself against herding behaviour is to develop an investment strategy driven by your personal circumstances, rather than market forecasts.
Following tried-and-tested advice, such as investing in growth assets when young, and allocating some capital to safe assets when older, will reap dividends.
Williams recommends becoming more attuned to your inner voice, and asking yourself critical questions, such as, “How do I know this assumption is true, and what would happen if I believed the opposite?” and “What information is missing that would help me to make this decision?”
Examine past decisions and outcomes, noting where your instincts were correct, or where you may have felt pressured. “Focus on what you can control and work from there,” says Williams.
Nkomo says it’s helpful to question a majority-held opinion.
“Just because everyone around you believes buying property is better than renting, you may feel pressured into adopting this view even though you may not agree with it,” she says. “Resist influence from strong-willed friends and family members, who may try to coax you into abandoning your own opinions.”
She recommends comparing the implied values of the herd with your personal beliefs. “If your friends try to persuade you to join a cryptocurrency scheme, but you feel you’ll regret it as it conflicts with your values - monetary or otherwise - then walk away.”
Shandu says a financial adviser or banker can guide you when you need advice about where to invest your money, or what you should use a loan for.
“Leave herding to animals and seek guidance from financial professionals,” he advises.
Tip: If poor financial decisions have resulted in over-indebtedness, it may pay to consolidate your debt.